Last week, we updated our assessment of capital outflows in China, noting that based on available information, it appears that outflows may have surpassed $300 billion from early July through mid-September. That figure comes from our analysis of July TIC data, Goldman’s assessment of underlying currency demand (comprised of outright spot plus freshly-entered forward contracts), and Nomura’s estimates for onshore spot intervention and offshore spot and forward meddling by the PBoC in September.
As we began to detail late last year when falling crude began to pressure the accumulated petrodollar reserves of the world’s energy exporters, and as we and finally countless others have discussed in the wake of China’s shift to a new currency regime, FX reserve drawdowns serve to tighten global liquidity and work at cross purposes with DM QE. This creates a dilemma for Fed policy as hiking rates could accelerate outflows from emerging markets thus putting further pressure on already falling USD reserves. In other words, in today’s world, a 25 bps hike by the FOMC would be amplified and transformed into something much larger once it reverberates throughout the global financial system.
Assessing how large the cumulative outflow from China may end up being is important as it proxies for the expected drain on global liquidity (or at least part of the drain on global liquidity, as we must also consider the possibility that net petrodollar exports turn deeply negative in the face “lower for longer” crude). Previously, we suggested that outflows could eventually reach $1.1 trillion. That figure was derived from a look at BofAML’s assessment of the size of the RMB carry trade, which is now unwinding.
Needless to say, rampant speculation that China is targeting a much larger devaluation than that implied by the August 11 “one and done” reset only serves to put more pressure on RMB, necessitating still more reserve drawdowns. Of course each round of intervention sucks liquidity out of the system which means Beijing must offset the tightening with RRR cuts and liquidity injections. But the very act of cutting rates and injecting cash is perceived by the market as easing, which puts more pressure on the yuan and the vicious, self-feeding loop is perpetuated.
On Monday, we get a fresh take on all of the above courtesy of Barclays who says that before it’s all said and done, China’s FX reserves could take a hit on the order of $1.2 trillion.
First, Barclays endeavors to explain when the adjustment will be sufficient for things to balance out or, alternatively, what will dictate the dynamics should the PBoC not allow for a deep enough adjustment:
An accurate picture of the scale of capital outflows along with new growth trend is crucial to understanding the extent of CNY depreciation needed and/or the sustainability of the market interventions/controls. Indeed, if policy makers are serious about having a marketdetermined exchange rate regime, the size of the real exchange rate adjustment will be enough at a point when capital outflows are largely financed by current account inflows or stable components of the capital account (FDI and portfolio outflows). On the flip side, if policy makers take a step back from the recent moves towards flexibility, increase their market interventions and implement controls then the scale of capital outflows and the new growth trend will determine the sustainability of such measures.
China’s slowdown coupled with the country’s economic transition to a consumption and services led model has decreased the extent to which outflows can be covered by current account surpluses:
Financing for capital outflows had been relatively straightforward when China was running very large current account surpluses. CA transactions fell below 8% in mid 2011 and have stayed low (around 5% of GDP including trade mis-invoicing) despite the increase in capital outflows. Weak global demand and competitiveness pressures as well as a push to rebalance growth away from exports to consumption have eroded the current account surplus in recent years.
And then there’s the infamous RMB carry trade, discussed in these pages on countless occasions:
China was able to offset capital outflows by increased borrowing from abroad, with total external debt standing at around USD1trn from different sources. We believe this borrowing captures a portion of the China carry trade – borrowing in USDs short term to fund RMB assets by onshore borrowers (corporates, banks and non bank financial entities). This increased borrowing was large enough such that China was able to not only compensate for outflows but also to accumulate reserves during the period of 2011-2014. Both FDI inflows and portfolio flows are now smaller than international borrowings. Absent these inflows, China would have been running down reserves for the last few years. Most of this recent financing has come from the increase in cross border borrowing by the Chinese private sector. We estimate that these flows have soaked up close to 30% of capital outflows over the last 5 years from practically 0% in 2008. Additionally, that these flows are short term in nature, denominated mainly in USDs and channelled to financial services and real estate sectors, adds to worries about their sustainability. About 75% of the current stock of roughly USD1.4trn of cross-border borrowing by the Chinese private borrowers has a maturity of less than one year.
Finally, here’s the “downside scenario”:
According to our measures, non-FDI capital outflows are 8-10% of GDP and the financing that may be available through the current account is 5-6% (inclusive of the trade mis-invoicing). The gap between the two is about 3-4% of GDP. This is assuming that outflows don't further accelerate from current levels. Greater flexibility in the exchange rate will help reduce the China carry trade and increase the repayment of international borrowings. Short-term debt as a percentage of GDP is running higher than historical averages at 4% of GDP and may decline from the current 10% of GDP. This means an additional outflow of about 5% of GDP.
Net FDI and portfolio flows currently add up to 2.5% of GDP, but these may dry up or reverse in the event of a serious enough growth shock. Flat net FDI and a reversal of portfolio flows similar to what happened in 2007 implies an outflow of 2% of GDP.
The above numbers suggest that in such a downside scenario there could be pressure on the central bank to provide about 10-12% of GDP in reserves to the market to offset outflows as well as hedging demand (which could be met by intervening in forward markets). This is roughly USD1.0-1.2trn – that would be about 30% of its current reserve portfolio.
And the puncline is this: "There would be a liquidity tightening onshore as these reserves are sold ... which implies the central bank needs to provide a 500bp cut in the RRR to keep liquidity conditions."
This is nothing new and indeed we've discussed it exhaustively, but it's worth reiterating why it's so important. Clearly, a 500 bps cut to a policy rate amounts to massive easing. Of course massive easing is usually associated with a weaker currency. In short, China's efforts to offset the devaluation pressure on the yuan necessitate outsized policy rate cuts that only serve to... exert more pressure on the currency.
As we've noted previously, if China ends up liquidating $1.2 trillion in reserves, that would (in a vacuum) offset more than 60% of QE3 and, based on the extant literature, put somewhere on the order of 200 bps of upward pressure on 10Y yields.
There are obviously any number of mitigating factors here, not the least of which is that it now appears the Fed is destined to trigger flights to safety no matter what it does, which could mean that USTs catch a bid from investors fleeing the sheer lunacy of central bankers but then again, when dovish leans by central bankers no longer boost risk assets we have a very serious problem, which means that in the end, if the market is banking on jittery investors' collective safe haven bid to fill the void left by China's UST liquidation, then it is effectively saying that the only thing that can save the world from China's massive reverse QE is the complete loss of central banker credibility.