How Beijing Is Responding To A Soaring Dollar, And Why QE In China Is Now Inevitable

While the topic of China's slowing economy has been a prominent fixture over the past week, first with the latest Chinese rate cut last weekend, followed by the announcement that China is once again lowering it target growth rate to 7% for the 2015 and onward, coupled with a warning that "downward pressure is growing" and that 2015 will be more difficult for the country than 2014, the one issue that has not gotten the attention it deserves is capital flight out of China, now that deflation is increasingly mentioned as an outright possibility for the country, and the reasons behind it.

As a reminder, China is increasingly impacted by the Fed's policies as a result of two things: weaker currencies around the globe, coupled with China's quasi-peg to the USD, which over the past week has soared to fresh 13 year highs on expectations that the Fed will hike this summer (further validated by today's jobs report which miraculously was not impaired by the second, and worse, Polar Vortex, thus destroying the narrative made so popular last year that cold weather in the winter is responsible for weak job reports). Needless to say, for a country which just posted its record trade surplus, and whose net exports are still the lifeblood of the economy, being pegged to the world's strongest currency has two consequences: concerns about imported deflation which will lead to even further economic slowdonw, and capital flight as faith in the Chinese Renminbi is increasingly shaken.

The WSJ touched on just this critical topic in mid-February when it reported that "Despite a record trade surplus and a steady inflow of investment capital, China’s banks posted net sales of foreign exchange in January, suggesting that capital was flowing out of the country during the month."

The WSJ continued:

Analysts said the foreign-exchange data, released Tuesday by the central bank, partly reflected declining confidence in the nation’s currency amid a slowdown in the economy, as exporters and individuals held on to foreign exchange rather than convert it into yuan.


They also said it was yet another signal the People’s Bank of China would need to offset the loss of those funds by reducing the percentage of deposits that banks must park with the central bank in case of financial trouble.

As was further explained, while the foreign-exchange data also include figures from commercial banks and other financial institutions, they mostly reflect purchases and sales by the central bank. The figure is seen as a rough guide to changes in domestic liquidity conditions.

Not helping things is the recent weakness in the Yuan, which as shown in the chart below, has recently tumbled to multi-year lows:


The WSJ's take: "The yuan’s weakness against the U.S. dollar of late has made many companies and individuals reluctant to convert their foreign funds into local currency. The yuan lost 2.5% against the increasingly robust U.S. dollar last year and another 0.8% this year."

But the biggest reason for the slide in the Yuan is that banks "have seen rising levels of foreign-currency deposits, and that is a sign that exporters and individuals are “not confident in the outlook for their own currency and don’t want to hold on to it."  said Dariusz Kowalczyk, an economist at Crédit Agricole in Hong Kong. He said he sees this as the key factor in the net foreign-exchange sales data. Mr. Kowalczyk said the market is looking for the yuan to fall further to 6.35 or 6.40 to the U.S. dollar from the 6.25 level it traded at Tuesday morning.

It is slowly getting there.

Fast forward to today, when overnight Barclays observed more of the same theme. In a report titled "Unprecedented surge in FX deposits", Barclays notes that the recent "Unprecedented surge" in FX deposits is reflective of growing expectations of CNY weakness vs the USD. It adds:

The latest banking statistics from the PBoC suggest a further increase in market concerns about the risk of CNY depreciation this year. According to the PBoC press release on banking statistics, total FX deposits in China surged by USD45.2bn in January 2015 to a total of USD655.7bn (comparatively, the increase for the whole of 2014 was USD108.4bn). While we have become aware that PBoC has made some methodological changes to banking deposits starting in 2015, the increase in January of USD45.2bn still marks a very large monthly increase in FX deposits compared with the historical series. This compares with a q/q decline of USD31.8bn in FX deposits in Q4 14, and we think the January increase cannot be fully explained by seasonal factors. Such a renewed jump in FX deposits is significant, in our view, and reflects the degree of FX pressure that has developed over recent months.

This is how said "surge" looked like:


That is not to say that the PBOC is doing nothing. Quite the contrary:

A separate and more closely watched data series – the change in financial institutions’ (FI) position for FX purchases – suggests that the PBoC has continued to intervene in the FX market to limit currency weakness as CNY fell towards the weak side of its trading band. As shown in Figure 3, FIs’ position for FX purchases fell again in January, dropping USD17.4bn following a decline of USD19.1bn in December. We believe this can be largely attributed to the PBoC’s FX intervention activity, even though data on the PBoC’s foreign assets/FX reserves have not been released.

Behold the PBOC's alleged intervention:


Barclays, like everyone else suddenly, is pessimistic about the prospects of a quick CNY jump. In fact, if anything, it took is shifting to a "controlled devaluation" camp, saying "Negative market sentiment on CNY may not abate quickly."

The renewed rise in FX deposits highlights the increasing currency pressures and the ongoing monetary dilemma that China is facing. Even though the authorities have kept USDCNY fixings broadly stable and have attempted to tame market expectations of policy changes through public comments, these efforts have failed to calm market expectations of CNY depreciation. This is reflected by a number of factors, including the rise in FX deposits, offshore USDCNH trading above the upper bound of the onshore USDCNY trading band, and the extreme skew in risk reversals in the FX options market. We do not see these factors abating? indeed, we expect USDCNH to continue to trade above USDCNY, with the risk that the basis will widen further."

The punchline: devaluation may be imminent:

As the USD has risen against global currencies, the market has likely become more concerned that China eventually will have to allow more CNY weakness versus the USD in order to tame REER appreciation. As we argued in CNY: Deflation, downturn and the deepening monetary dilemma, 12 February, amid slowing inflation and rising outflows, the costs of limiting CNY weakness are growing – including the unintended effect of placing more stress on CNY market liquidity and interest rates, rendering liquidity easing efforts less effective.

Which means the PBOC's recent easing will do absolutely nothing to offset not only the ongoing surge in the USD, but the near historic collapse in the EUR, one of China's main trading partners. As a result China will be swamped be exported deflation not only out of Japan, as has been the case since the start of Abenomics, but now, thanks to Q€, from Europe as well.

And yet, the paradox is that China is caught between a rock and a hard place: devalue too much, and the capital outflows will accelerate, not devalue enough, and the mercantilist economy gets it:

... the recent surge in capital outflows probably means that Chinese authorities have become even more cautious about fuelling CNY depreciation expectations in the near term. Indeed, China typically has refrained from making policy adjustments when selling pressures on the CNY are heaviest. This may preclude an imminent band widening, but we do not rule out the authorities undertaking policy adjustments when CNY selling pressures subside. In the meantime, the path of least resistance is to move USDCNY fixings higher.


Supporting our view that a band widening is likely, even if not imminent, is the fact that Premier Li mentioned in the opening speech of the National People’s Congress (NPC) that the government would allow the RMB exchange rate to “float more freely”. It is important to note that the phrases on “increasing flexibility/expanding the floating range” are not mentioned at every NPC speech. Interestingly, these phrases were included in the NPC speeches of 2012 and 2014, years during which China allowed the trading band to be widened.

What all of the above means is that China is suddenly finding itself in an unprecedented position: it is losing the global currency war, and in a "zero-sum trade" world, in which global commerce and trade is slowly (at first) declining, and in which everyone is desperate to preserve or grow their piece of the pie through currency devaluation, China has almost no options.

Well, that's not true. Because if China wants to enter the global currency wars, and it will soon have no choice, it has - according to Cornerstone - several options with which to stabilize its economy, but really all of which, due to the size of China's epic credit and investment bubbles, and keep in mind that China's housing bubble has not only burst, but is now deflating at a faster pace than what happened in the US after Lehman...

... boil down to just one: QE.

From Cornerstone:

Do you remember that from 2007 to late 2008, U.S. fed funds dropped 500 bp, and then the Fed still needed to do QE? The backdrop for China looks a bit similar. We had a credit bubble, they have a credit bubble. We had a housing bubble, they have a housing/investment bubble. Will China eventually have to go down the same path as the U.S., and the Eurozone? Roberto Perli believes the PBoC will first cut rates to 0%, before contemplating QE.

There you have it: the flowchart for what is in store for the world for the next 12-24 months - an ongoing deterioration in Chinese economic conditions, coupled with a weaker, but not weak enough, currency, before the PBOC first go to ZIRP, and then engages in outright QE.

And once China, that final quasi-Western nation, proceeds to engage in outright monetization of its debt, then and only then will the terminal phase of the global currency wars start: a phase which will, because global economic growth and that all important lifeblood of a globalized economy - trade - at that point will be zero if not negatve, will see an unprecedented crescendo of money printing by absolutely everyone, before coordinated devaluations mutate into uncoordinated, and when central bank actions morph from "all for one" to "each man for himself."

At that moment, what had been merely currency "war" will finally transform into a shooting one.