Earlier this month, we asked if the market was being deceived about the pace of capital outflows in China.
Our concerns came on the heels of a rally in EM FX and other assets that may have been fueled by a “better-than-expected” read on China’s reserve drawdown in September. The figure came in at “just” $43 billion, which of course made no sense because on one measure, outflows totaled more than that by the middle of the month.
This is important because as we outlined three weeks after the deval, the monthly read on China’s FX reserves has to a certain extent become the new risk on/off trigger for the market which means that if the data is unreliable or otherwise opaque, then investors will be operating with bad information. That is, what we really want to know is how much pressure there is in terms of capital outflows, and to the extent that China’s official FX reserve data doesn’t capture that, the data isn’t a useful indicator of where EM is headed on a more general level.
As Goldman began to discuss in September, Chinese banks appear to be absorbing some of the outflows using their own books. Here’s how they explained the situation last week:
Given possible PBOC balance sheet management (e.g., short-term transactions and agreements between with banks, e.g., forward transactions, FX entrusted loan drawdown or repayment), we interpret the FX reserves data with caution, as it might not give a complete picture of the FX flow situation. The large gap between today’s data and the other PBOC data for September suggests that banks might have used their own spot FX positions to help meet some of the outflow demand, although banks’ overall FX positions might still have been squared with the PBOC via forward agreements.
In short, our argument has been that much like the NBS will obscure any weakness below 7% in China’s GDP data, the PBoC will do “whatever it takes” (central bank pun fully intended) to make sure that the market doesn’t get wind of the fact that there’s still a tremendous amount of pressure in terms of capital outflows.
Now, the word is apparently out. Here’s Bloomberg:
The People’s Bank of China and local lenders increased their holdings in onshore forwards to $67.9 billion in August, positions that would boost China’s currency against the dollar. The amount is five times more than the average in the first seven months, PBOC data show. The positions are part of a three-stage process to support the currency without immediately draining reserves, according to China Merchants Bank Co. and Goldman Sachs Group Inc.
Standard central-bank intervention to support a currency generally involves selling dollars and buying the home tender. In this case, China’s large state banks borrowed dollars in the swap market, sold the U.S. currency in the cash spot market and used forward contracts with the central bank to hedge those positions.
"If you can intervene without actually diminishing your reserves, it’s somehow viewed as better," said Steven Englander, global head of Group-of-10 foreign exchange-strategy in New York at Citigroup Inc. Such central-bank activity "may not look quite as dramatic as the sale of reserves, and they may prefer that optically," he said.
Using derivatives for intervention had the benefit of delaying any decline in the PBOC’s $3.5 trillion trove of foreign-exchange reserves, helping calm investors rattled by an economic slowdown and a slumping stock market. It was also faster as the monetary authority’s managers didn’t have to liquidate assets such as U.S. Treasuries to raise the dollars needed for direct yuan purchases.
Major Chinese banks borrowed dollars in the onshore swap market in late August and September, and then undertook "heavy dollar selling" in the spot market, said Frank Zhang, head of foreign-exchange trading at Shenzhen-based China Merchants Bank.
The PBOC then came in to offset, or "square", the positions with the banks, essentially taking on their trades onto its own balance sheet, according to Goldman Sachs.
On a practical level, buying yuan forwards means the PBOC wouldn’t drain yuan liquidity out of the system as it would otherwise by buying its own currency in the spot market. Policy makers cut interest rates and the reserve-requirement ratio in August, partly to replenish the funds drained during intervention.
"If you have a transaction that settles down the road, the actual liquidity impact in the short term may not be as dramatic," said Citigroup’s Englander. "Down the road you can’t avoid it."
In the simplest possible terms (although really, this isn't that complex a transaction to begin with), they're just kicking the can in an effort to control the optics around the deval, which would be fine if everyone realized what's going on, but rest assured they do not, because no matter how many Bloomberg or WSJ articles are published on the subject, the market (or the machines) will still read the headline figures and make a snap judgement about the extent to which the pressure on the yuan has mitigated.
At the end of the day, the takeaway is simply this: the narrative around Chinese capital outflows is extraordinarily important right now, and indeed, it's influencing the Fed's reaction function. Even as Beijing doesn't necessarily want the Fed to raise rates, the PBoC doesn't want to lose complete control of the narrative either, which is why you can expect to see more efforts on China's part to mitigate near-term FX reserve burn, even if it means stacking the deck against the yuan down the road. And really, who can blame them? The entire world is involved in the largest can-kicking experiment of all time, so why should China's central bank be any different?