Officially, China has maintained quasi capital controls for years: on paper no individual is allowed to move more than $50,000 out of the country in any given year while Chinese companies can exchange yuan for foreign currencies only for approved purposes.
Unofficially, China's capital controls had been skirted for years, leading to massive capital outflow from the nation over the past decade, leading to such aberrations as massive luxury housing bubbles in places such as Vancouver, London, New York and San Francisco, and seemingly middle-class Chinese politicians and oligarchs sporting Swiss bank accounts funded in the hundreds of millions (or billions).
Just last March, we explained the schematic of how easy it is to avoid Chinese limitation on outflows, using nothing more than a UnionPay credit card and a trip to Macau. Here are the highlights:
China's underground money is flowing across the border into the gambling hub of Macau, a former Portuguese colony that like Hong Kong is an autonomous region of China. And the conduit for the cash is the Chinese government-supported payment card network, China UnionPay.
In a warren of gritty streets around Macau's ritzy casino resorts, hundreds of neon-lit jewellery, watch and pawn shops are doing a brisk business giving mainland Chinese customers cash by allowing them to use UnionPay cards to make fake purchases - a way of evading China's strict currency-export controls.
On a recent day at the Choi Seng Jewellery and Watches company, a middle-aged woman strode to the counter past dusty shelves of watches. She handed the clerk her UnionPay card and received HK$300,000 ($50,000) in cash. She signed a credit card receipt describing the transaction as a "general sale", stuffed the cash into her handbag and strolled over to the Ponte 16 casino next door.
The withdrawal far exceeded the daily limit of 20,000 yuan, or $3,200, in cash that individual Chinese can legally move out of the mainland. "Don't worry," said a store clerk when asked about the legality of the transaction. "Everyone does this."
The practice violates China's anti-money-laundering regulations as well as restrictions on currency exports. Chinese authorities also fear the UnionPay conduit is being used by corrupt officials and business people to send money out of the country.
The practice was so popular it had promptly gained epidemic proportions: "In Macau, UnionPay card transactions reached 130 billion Macau patacas ($16.77 billion) in just the first four months of 2012, up from 88.1 billion patacas in all of 2011, according to a confidential report by Macau's banking regulator, the Macau Monetary Authority reviewed by Reuters. Around 90 percent of those transactions were "highly concentrated in jewellery, ornament and luxury watch sales", the report said.
If that rate persisted for the full year, UnionPay sales in Macau for all of 2012 would have reached nearly $50 billion - nearly $45 billion of it for jewellery-related sales, a figure exceeding even Macau's total gambling revenues that year.
"Are these actual transactions? Where does this money come from?" the deputy head of the Monetary Authority, Wan Sin Long, asked in the document.
The answer, of course, is no. Also, the question is not where the money came from - the answer is some of the $22 trillion in deposits accumulated legally and/or illegally on the mainland, the question is where it is going after it was cashed out in Macau (for the answer look at soaring real estate prices in the ultra luxury segment in developed countries), and also why was China allowing this - after all none of this was a secret to either Chinese citizens, regulators or politicians?
To wit: "It's unclear why the central bank, the Peoples Bank of China (PBOC), hasn't cracked down harder on the practice, although the documents Reuters reviewed show the bank was aware it had become a growing problem."
The answer to the second is for years, many top Chinese politicians were themselves using this pathway to bypass the capital controls, leading to hundreds of billions of funds linked to China's most "respected" politicians to find its way into offshore bank accounts.
To be sure, this practice was greattly limited when Xi Jinping came in power and enacted substantial reforms which limited much of this grotesquely open flaunting of Chinese capital account rules. Indirectly, this has led to the recent collapse in Macau GDP - whose businesses no longer booked billions in fake "transactions" - as shown in the chart below:
However, judging by what remains the best downstream indicator of Chinese capital outflows, namely the ongoing appreciation of luxury real estate in the US, Canada (see "Chinese buyers spike Vancouver's luxury home market by 79%"), and the UK, while the Macau "money laundering channel" may have been plugged many others, both known and unknown remain.
And now that China has officially commenced a regime of currency devaluation, and has been forced to liquidate as much as an estimated $200 billion in reserves in just the past month to maintain the value of the Renminbi, capital flight has become the biggest and most direct threat to the Chinese regime and the economy.
The reason is that while China may succeed in maintaining an orderly pace of FX depreciation, if the local population is concerned it will lose substantial purchasing power in the coming months and years, it will accelerate the capital flight from the country, forcing even greater reserve liquidation as the government finds itself defending not only the capital but also the current account, not to mention the sheer capital flight panic resulting from the crashing stock market.
This is why as the WSJ reports overnight, "China is imposing fresh controls to prevent too much money from leaving the country, in an effort to keep badly needed funds at home to battle a deepening slowdown in the world’s No. 2 economy."
Specifically, the PBOC said Tuesday that it would make it "more expensive for investors to pressure the yuan to weaken against the U.S. dollar by adding conditions to futures contracts."
Some of the country’s largest lenders, including Bank of China Ltd. and China Citic Bank Corp., are beefing up their internal checks on large amounts of foreign-exchange conversions by their corporate clients, according to Chinese banking executives. Meanwhile, financial regulators, together with the country’s security forces, are stepping up efforts to rein in illegal money-transfer agents who make a living by helping people move money out of China.
The reason, as explained above, is that "China—long a catch basin for the world’s money—is starting to see that money trickle out. A weaker currency generally prompts investors to look elsewhere to put their cash and would complicate the government’s efforts to generate spending and bolster economic growth."
The WSJ correctly points that while it is impossible to accurately quantify just how much capital flows out of the mainland, one can venture a guess: "economists point to indications that money is leaving. China’s foreign-exchange reserves, which last year nearly reached $4 trillion, have shrunk by more than $341 billion since then."
Others look at the simplest, and most transparent indicator available - offshore real estate investments: "Property-services firm CBRE recently estimated that Chinese investment in overseas commercial properties, which is a proxy for outbound residential investment, totaled $6.5 billion in the first half of this year, putting it in position to surpass 2014’s total of $10.5 billion."
For now, the administration is seeking to keep the calm at all costs: after all, what better way to spark a capital exodus than with very vocal, and very effective capital controls. Just look at Greece:
PBOC officials have struck a more sanguine note. In recent days, they have echoed comments last month from top central-bank official Yi Gang, who said capital flows in and out of the country had remained “normal,” though he pledged to increase monitoring of cross-border money movements.
Outflows don’t appear to have reached alarming levels, and Beijing has plenty of firepower to curtail them. For example, its huge foreign-exchange reserves give it ample room to support the yuan’s value and make it attractive for investors.
Others point to the PBOC's most direct approach when dealing with speculation: any attempts to short the currency from outside will be met with aggressive currency intervention to burn the speculators, as has happened for years.
Longer term, some investors are betting Beijing will continue to open its vast capital markets to the outside world, making its currency more attractive. “It would be dangerous for investors to be shorting the yuan given the stated intention to open up the domestic capital markets over time,” said Andy Seaman, a portfolio manager at London-based investment firm Stratton Street.
Well, no: shorting the yuan in a regime of devaluation is precisely what investors should do, however it is the dramatic intervention by the PBOC in the open market that has driven the relaxed fixing from 6.41 back to 6.36 in a week, that is what is most concerning to shorts. However, as we have explained over the past month, such intervention is costing the PBOC hundreds of billions in liquidated reserves, read sold Treasurys. With every incremental intervention, Chinese reserves drop, and may continue to do so until such time as they reach precarious levels. At this point China would invite the truly big speculators to short its currency a la Soros and the Bank of England. And since China has a very finite supply of reserves to draw from, it will (or should) be very careful how it engages the speculators.
This is also why having launched the devaluation as official policy marked a sea change for China, as Deutsche Bank recently commented, one which most likely will not have a happy ending.
But the reason why China has to scramble is that while historic capital outflows have been moderate, it is the recent devaluation that has sparked a sea change in perceptions about currency stability:
Outflows could worsen in coming months should China’s currency weaken further or its economy show new signs of faltering. Recent negative economic data has called into question China’s ability to meet its 2015 annual growth target of about 7%. “Capital outflows could get worse in the third quarter because of the deprecation expectations for renminbi,” said Zhang Ming, a senior economist at the Chinese Academy of Social Sciences, a government think tank, using an alternative name for the yuan.
Indeed, it's all about expectations: and since China needs to boost exports and stimulate its economy - which is the fundamental reason why it proceeded with devaluation in the first place - any stop gap measures to halt the devaluation are doomed to fail.
Which is why the most recent escalation in capital controls will only get worse. It also includes such gimmicks as a "blacklist" of people with a track record of capital outflow wrongdoing. “Banks [that] fail to spot those on the blacklist or turn a blind eye on it will be punished and fined by the regulator as well,” an official at Citic said.
This war with capital flight also explains yesterday's surprising announcement which we documented previously, to require a 20% margin on all currency forwards:
The new rule instituted by the PBOC starts Oct. 15. It will require banks use a type of financial contract, known as currency forwards, to buy dollars while selling yuan to set aside reserves with the central bank. Under the new requirement, a bank that has sold a total of $100 of the so-called currency forwards over the course of a month must deposit $20 at the central bank. The reserves will be held at zero interest for a year.
The reserve requirement is aimed at “fending off macro-financial risks,” the PBOC notice said.
And while some investors saw the move as a way to help the yuan, such as Tommy Ong, head of wealth-management solutions, treasury and markets for Greater China at DBS Bank in Hong Kong, who noted that "The central bank wants to dampen short-term speculation of renminbi selling,” said Tommy Ong, the truth is that such enforcement which reduces market liquidity will hurt first the markets, then the economy.
WSJ admitted as much when it said that "traders Tuesday said they were struggling to give clients quotes for how many yuan a dollar buys onshore on forward contracts, as the cost of holding reserves under the new rules remained unclear."
Additionally capital account crackdowns are taking place domestically:
At home, Chinese officials have intensified a crackdown on what are known in China as underground banks, which Chinese nationals often use to shift money in and out of the country despite tight capital controls. Meng Qingfeng, vice minister of public security, said late in August that those money-transfer agents remained “rampant” despite repeated crackdowns on them, according to the official Xinhua News Agency. Mr. Meng also urged police around the country to better coordinate with the central bank in the campaign, which will run through the end of November.
In summary: while China is doing everything in its power to not give the impression that it is panicking, the truth is that it is one viral capital outflow report away from an outright scramble to enforce the most draconian capital controls in its history, which - as every Cypriot and Greek knows by now - is a self-defeating exercise and assures an ever accelerating decline in the currency, which authorities are trying to both keep stable while also devaluing at a pace of their choosing. Said pace never quite works out.
So what happens then: well, China's propensity for gold is well-known. We would not be surprised to see a surge of gold imports into China, only instead of going to the traditional Commodity Financing Deals we have written extensively about before, where gold is merely a commodity used to fund domestic carry trades, it ends up in domestic households. However, while gold has historically been the best store of value in history and has outlasted every currency known to man, it is problematic when it comes to transferring funds in and out of a nation - it tends to show up quite distinctly on X-rays.
Which is why we would not be surprised to see another push higher in the value of bitcoin: it was earlier this summer when the digital currency, which can bypass capital controls and national borders with the click of a button, surged on Grexit concerns and fears a Drachma return would crush the savings of an entire nation. Since then, BTC has dropped (in no small part as a result of the previously documented "forking" with Bitcoin XT), however if a few hundred million Chinese decide that the time has come to use bitcoin as the capital controls bypassing currency of choice, and decide to invest even a tiny fraction of the $22 trillion in Chinese deposits...
... in bitcoin (whose total market cap at last check was just over $3 billion), sit back and watch as we witness the second coming of the bitcoin bubble, one which could make the previous all time highs in the digital currency, seems like a low print.
We bring all this up in case there is any confusion why Bloomberg just carried a huge centerfold piece explaining why CDS-inventor Blythe Masters has suddenly become the digital currency's most vocal pitchman and is betting it all on bitcoin, in "Blythe Masters Tells Banks the Blockchain Changes Everything."
Yes, bitcoin may be slowly but surely leaving the domain of the libertarian fringe, but in exchange it is about to be embraced as the most lucrative and commercial "blockchained" way to capitalize on what may soon become the largest capital outflow in history, with "pioneers" such as Blythe front and center to capitalize on each and every outflowing Bityuan.