In light of the most recent GDP data out of China which showed the economy growing at the slowest pace in six years, we thought it time to revisit what we recently called “the flowchart for what is in store for the world for the next 12-24 months.” As we noted in early March, China faces a decelerating economy and a currency conundrum, the combination of which may eventually leave the PBoC with little choice but to first cut rates to zero then engage in outright QE.
In short, China needs to devalue in order to counter weakening economic growth and slumping exports. Maintaining the dollar peg at a time when the dollar is surging has led to double-digit REER appreciation for the yuan, a decisively undesirable outcome for the country’s export-driven economy in the face of still sluggish global demand. Additionally, this is all serving to hamper the PBoC’s existing liquidity easing efforts. Here’s Barclays summing up:
CNY overvaluation is getting more extreme, with USDCNY remaining relatively stable while trade partner currencies fall sharply versus the USD. Our BEER model estimates that the CNY is around 20% overvalued, making it one of the most expensive currency globally.
FX intervention to limit CNY weakness (ie, selling USD) is having the effect of tightening domestic CNY liquidity. The PBoC does have room to cut the reserve requirement ratio (RRR) rate to offset the liquidity impact of FX intervention, as the current RRR level of 19.5% is high by historical standards – the ratio was as low as 6% in 2002. However, a further drain of liquidity may not be appropriate if a step-up in monetary easing is needed to counter a sharper growth slowdown and to bring down elevated funding costs.
The global recovery remains uneven and desynchronized, with the US being the sole engine of growth. While China’s exports are so far performing better than other EM Asian economies’, the recent sharp CNY REER appreciation might have a dampening effect on Chinese exports to countries apart from the US.
Long story short: preventing CNY depreciation is becoming very, very costly in a world characterized by a strengthening USD and still raging currency wars across DM central banks. This has fueled speculation that China, no longer able to take the economic pain, will eventually give in, and that expectation has in turn fueled capital outflows. Of course capital outflows may make it more difficult to devalue (you don’t want to throw fuel on the fire), which means that in the end, China is stuck with few options and as JPM outlines, Q1 marked the fourth consecutive quarter of capital outflows bringing the total to $300 billion over the period. Here’s more:
Chinese FX reserves were depleted for a second straight quarter, by $70bn cumulatively during Q4 2014 and Q1 2015 as China supported its currency. At the same time a current account surplus in Q1 combined with a drawdown in reserves suggests that capital outflows from China continued for the fourth straight quarter…
This brings the cumulative capital outflow over the past four quarters to $300bn. Again, we deduct capital inflow from the change in FX reserves minus the current account balance for each previous quarter to arrive at this estimate. The last time China suffered such pace of capital outflows was during 2012 when $165bn of capital left during the last three quarters of that year. And before then it was during the Lehman crisis when China suffered capital outflows, but much smaller in size (around $60bn of capital left China during the second half of 2008). So the 2012 capital outflow episode is more comparable in size to the current one…
The capital outflow appears to be driven by the more volatile “Other Investment” item in balance of payments. And within this item there are three components that saw the most significant swing during China’s most recent capital outflow episodes, i.e. the last three quarters of 2012 and the past four quarters (from Q2 2014 to Q1 2015): “short term trade credits” within foreign assets, “currency and deposits” within foreign assets and “short term loans” within foreign liabilities. The first component averaged -$10.5bn per quarter outside the above two episodes and -$26.0bn per quarter during the two episodes. A negative sign means that Chinese companies extended short term trade credit to foreign companies, which is equivalent to Chinese companies lending to foreign entities. In other words during the past two capital outflow episodes Chinese companies or the subsidiaries of foreign companies in China appear to have used trade credits to increase their long dollar exposure or to reduce their long renminbi exposure..
The second component, “currency and deposits” in foreign assets, averaged - $15.3bn per quarter outside the two episodes and -$28.0bn per quarter during the two episodes. A negative sign implies a capital outflow ? i.e. it means that during the past two capital outflow episodes Chinese companies or the subsidiaries of foreign companies in China held on to their foreign currency and boosted their dollar or foreign currency deposits…
The third component, “short term loans” in foreign liabilities, averaged $18.7bn per quarter outside the above two episodes and -$23.4bn during the two episodes; i.e. it experienced an even bigger swing that the first two components. A positive sign implies borrowing of Chinese residents from abroad (a capital inflow) while a negative sign implies repayment of foreign loans by Chinese residents (a capital outflow). The deterioration of this item is thus likely caused by 1) foreign residents reducing their renminbi deposits or previously extended short term loans to Chinese entities or 2) Chinese companies unwinding previous short dollar exposure by repaying foreign currency loans to foreign banks, e.g. Hong Kong banks.
And while JPM believes the above does not “suggest that a new trend of broad-based capital outflows is emerging in China” but rather reflects “opportunistic currency and interest expectations,” it most certainly underscores the precariousness of the situation if you’re Beijing, or, as we have put it on a number of occasions: “devalue too much, and the capital outflows will accelerate, not devalue enough, and the mercantilist economy gets it.” Whether this rather untenable situation ultimately deadends in Chinese QE remains to be seen but given the economic situation, China may have no choice but to devalue especially once the country's margin-driven equity bubble distraction comes to an unceremonious end.
Some Saturday morning headlines to ponder as you consider all of the above:
- CHINA HAS EASING ROOM, WON'T NECESSARILY USE IT: PBOC'S ZHOU
- CHINA HAS MORE ROOM FOR EASING THAN OTHER NATIONS: PBOC'S ZHOU
- CHINA HAS EASING ROOM IN RESERVE RATIO, INTEREST RATES: ZHOU
- CHINA NEEDS TO ADJUST MONETARY POLICY CAREFULLY: PBOC'S ZHOU