China Is Now Left With Just Three Options, And They Are All Equally Bad

Last Friday's forceful intervention by the PBOC, in which the central bank hiked the reserve requirement for FX forwards trading from 0% to 20%, was a warning shot at the gathering yuan shorts who managed to briefly send the Chinese currency below 6.90 against the dollar last week, after losing 4% of its value in the past month, and bringing the cumulative decline against the dollar to 10% since April, a far steeper drop than seen during the 2015 devaluation.

The yuan slide had come amid growing speculation that Chinese authorities are more willing to let their currency weaken along with market forces and an escalating trade war, at least for as long as they felt any capital account leakages are contained and manageable.

And yet, despite China's long overdue intervention - after all, once capital flight begins as new holes in the capital account are uncovered, it would be too late to prevent a repeat of the 2015 scenario - the debate about Chinese currency depreciation and what happens next with Chinese policy gathered pace, with ING last week proposing that this latest attempt to "nuke the shorts" is doomed to failure, just like previous unilateral FX interventions.

Over the weekend, JPMorgan echoed ING's skepticism, writing that despite Friday's PBoC announcement and despite the cumulative depreciation over the past two months, "the pressure on the Chinese renminbi to decline further against the dollar is unlikely to go away if trade tensions with the US escalate further from here."

Meanwhile, in a move that puzzled many China watchers, at the same time that the PBoC announced an increase in the reserve requirement ratio for fx forwards trading, China announced that it would implement tariffs on $60bn of imports in response to a threat by the US earlier this week to raise the tariff rate from 10% to 25% on $200bn of Chinese exports to the US, prompting some to speculate that the FX intervention was merely implemented to prevent a collapse in the yuan beyond 7.00 vs the dollar as the market freaked out about the latest Chinese retaliation.

Of course the escalating tit-for-tat dynamic - which we have discussed extensively in the past - is familiar: as JPM explains, an argument can be made that this threat by the 'hard case' US to raise the tariff rate is creating a vicious circle:

... the more the Chinese currency depreciates vs. the dollar, the more it may be seen by the US administration as an attempt to offset their tariffs and the more the US tariff rate will be raised.

Last Friday, Larry Kudlow confirmed as much saying that Trump won't back down as "China's $60BN response is weak", while on Sunday, National Security Advisor John Bolton warned that much more is still coming:

  • *BOLTON: WILL TAKE TRADE WAR `FAR ENOUGH TO GET CHINA TO CHANGE'

But it's not just trade war that is weighing on the Yuan: according to JPMorgan, the PBOC's recent scramble to ease monetary policy at the expense of fx policy "has seen a collapse in domestic interest rates with certain money market rates down almost 200bp YTD." This contrasts with the Fed’s continued tightening, which keeps pushing US interest rates up. As a result, the gap - or the negative carry - between Chinese and US short-term interest rates is approaching zero, making it even less expensive for market participants to hold short renminbi/long dollar positions.

The chart below shows the difference between the 3-month SHIBOR rate in China vs. the corresponding interbank rate in the US: this gap collapsed to 60bp currently vs. 320bp at the beginning of the year, effectively wiping out the cost of shorting the Chinese currency vs. the dollar.

All else equal, the collapse in the short-term yield differential means that as trade war continues to ramp up and as China continues to ease conditions in response, the attack against the Chinese currency will only intensify forcing the PBOC to scramble plugging a growing number of leaky holes in the proverbial dyke, until finally the whole thing collapses.

It won't happen overnight, however, because one thing China has going in its advantage, at least for now, is risk-on momentum in its capital markets offsetting FX capital flight, i.e., China continues to have strong portfolio flows into both Chinese bonds and equities by foreign investors, which have acted as a cushion. From JPM:

Foreign investors have been strong buyers of Chinese onshore bonds this year, and these inflows appear to have continued at a strong pace up until July. This is shown in Figure 4, which shows the change in holdings of Chinese onshore bonds both unadjusted and adjusted for market value changes.

What is also striking is that foreign investors also poured money into Chinese onshore equities this year, either to take advantage of more attractive valuations or in response to MSCI inclusion of A-shares. This is shown in Figure 5, which shows that adjusted for market value changes, foreign investors poured money into onshore equities each month this year with the exception of February. The total flow in the first half of the year was a strong $43bn. These portfolio inflows provide leeway to Chinese policymakers and create more room for currency depreciation as they can act as an  offset to other sources of capital leakage.

How much longer this inbound capital "momentum chasing" will continue is unclear, especially with Chinese A-shares tumbling into a bear market over the past few months, and approaching year lows. Meanwhile, with or without capital inflows, ad whether the PBOC forced short squeeze works, JPM warns that the yuan is nearing a key psychological level.

With the CNH rate very close to the level of 7.0 and the CFETS trade-weighted index very close to the level of 92, its previous historical low seen in May 2017, we believe that the Chinese renminbi and Chinese policy stand at a critical juncture.

So how, according to JPMorgan, would Chinese policymakers respond to further depreciation pressures?

Their base case is simple: the fiscal response, in particular infrastructure investment, and loan growth will pick up substantially in the coming months but that assumes that trade tensions do not worsen significantly from here. Which - as discussed above - they will, simply because neither Trump nor Xi will concede uncle the market forces them to cry uncle (and with the S&P just shy of all time highs, it certainly won't be the Donald doing so first).

On the other hand, JPM writes that if the prospective fiscal and credit stimulus disappoints and/or the trade war with the US escalates, market pressure on the Chinese renminbi will intensify. At that point the three choices Chinese policymakers would face would all be far more difficult:

  1. intervene in currency markets to offset market pressures risking a new wave of reserve depletion;
  2. raise interest rates to defend the currency causing monetary tightening and risking economic weakness; or
  3. let the currency depreciate beyond the above critical levels along with market pressures risking capital outflows and a more abrupt move

It goes without saying that all three choices have severely adverse consequences for the market and the global economy, and yet Donald Trump would be delighted with any of the three. After all, recall what One River CIO Eric Peters said last week when he explained what the easiest way to bring China's system crashing down was:

“The best way to bring Beijing to its knees is by running a tight monetary policy in the US. China has the world’s most overleveraged, fragile financial system.” 

In 2008, China’s total debt-to-GDP was 140%. It is now roughly 300%, while GDP is slowing. “The economy is held together by capital controls. If those fail, the whole system fails.”

The capital flight in 2015/16 cost the government $1trln in reserves, and that was with ultra-dove Yellen in charge. Imagine what would have happened with Volcker at the helm. The Chinese are dying to get their money out.”

Peters then laid out what may be the best long-term foreign policy recommendation for Trump, or any other administration: crash China...

Engineering a decade of rolling Chinese financial crises would be the most effective foreign policy the US could run." Forget about the South China Sea, don’t bother with more aircraft carriers, just let Beijing try to cope with their financial system.

“And we’re 80% of the way there – we instigated a trade war, implemented a massive fiscal stimulus, which created the room to raise interest rates. The combined policy mix makes capital want to leave at the same time it makes the dollar more attractive and effectively shuts down new investment inflows to China.”

... because if the US doesn't do it first, China will have no problems doing it to the US when the time comes some time in the next 2 decades.

Comments

gatorengineer Stan522 Sun, 08/05/2018 - 17:44 Permalink

There are special idiots who write these articles.....

1) China is devaluing in the face of sanctions.  Just that simple

2) Currency outflows meet anti-aircraft gun...

Hedge is getting more Drivelesque everyday.  The US has not contrary to tweets tariffed anything of substance, we have 25% on 60B or roughly 5 percent of the chinese exports....  Come on Tyler you arent much ahead of huffpo these days.

In reply to by Stan522

Brian gatorengineer Sun, 08/05/2018 - 17:47 Permalink

They always have the option of one-time hard currency devaluation.  If, for example, they devalue 25% overnight, then they can start slowly strengthening.  This would prevent all desire to move capital out (no capital outflow) because the decline is already past, and currency appreciation is taking place moving forward.

This option solves all the problems you've suggested in the "all options are bad."

 

In reply to by gatorengineer

Free This Oldguy05 Sun, 08/05/2018 - 19:25 Permalink

China paipa taiga! Now inserting itself into the quagmire of the muddle east to give soldiers training, so they can go home to put down the revolution that is coming their way.

Ain't life kinda funny like that?

Psssssst, central planned economies don't work China. Building ghost cities did nothing for ya. One big fat Xi mal-investment after another!

they peg to king dollar, they devalue all the time - non-answer

In reply to by Oldguy05

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In reply to by eforce

thisandthat are we there yet Tue, 08/07/2018 - 08:23 Permalink

Trump hasn't won anything yet; barely beating a spastic war criminal mobster isn't particularly outstanding achievement, and that's about it, this far. Even anything he may eventually achieve, can be easily be undone afterwards; just look at Reagan...

As for China, embrace your reaper... it's only a matter of time, and will only become worse...

In reply to by are we there yet

JIMSJOE2 Free This Mon, 08/06/2018 - 07:46 Permalink

They no longer peg to the dollar but a basket of currencies. Dollar strengthens, the currency in the basket becomes weaker in relation to the dollar and the yuan weakens. The yuan has been trading in a range for over 10 years ever since removing the dollar peg.

    China is not going to the Syria for training on putting down riots at home. US backed Chinese terrorists have moved into Syria and China sees this as a way to destroy them once and for all.

     There is more to tariffs that meets the eye. Armstrong Economics computer models are forecasting by 2032 the shift of financial power from the west to China will have become complete. Asia is becoming the new powerhouse. The west want to stop this but it cannot be stopped. The models forecast that around 2025 the US starts to have major problems funding their day to day operations. The dollar will weaken drastically and treasuries will be not bought. We are just beginning to see the decline here with trillions in pensions destroyed along with savors. With Bernanke keeping rates to low and too long he has helped destroy the US as Draghi has done in Europe. In 2 or 3 years we see the first 25% cut in social security monthly benefits as the Trust fund runs out which is currently paying 25% of these benefits. Social Security itself runs out between 2025 and 2030 depending on treasuries. The largest holder in the US of these is the agency. When these go south and the US can no longer afford to pay interest, the program collapses. Many US government agencies hold large amounts of these also and again they are all in the same boat. This is one reason why the US government will not survive in its present form.

     Now as millions lose benefits the amount of money that would normally flow into the real economy will have stopped creating tax revenues to drop drastically at all levels of government.

     As China has been moving to a capitalistic economy the US and the west has been moving to a more socialistic economy. The fact is most countries including the west have centrally planned economies. Here in the US it is the FED who controls economic conditions by lowering or raising rates, banks reserve requirements and controlling the money supply. It is Congress who passes tax increases or decreases and place more regulation on businesses. It is also at the state and local level that increase taxes and also add more regulation. This model is exactly like China's. Replace the FED with the PBOC and Congress with the National People's Congress with provinces and cities doing the same as in the US. The fact is that China saw how in the US regulations and taxes at all levels of government were destroying businesses so China went the other direction. They also saw how this was destroying the US economy. No US firm would have built factories in China if they had to face a huge amounts of regulations just to build in spite of low labor costs. In the US to build a major development requires an environmental impact statement which is lengthy, costly and before you even build you are in the hole millions.

     China wants growth and jobs and the US thru bureaucrats are doing the opposite. Europe is doing the same as the US.

In reply to by Free This

Free This JIMSJOE2 Mon, 08/06/2018 - 09:54 Permalink

You are right and you are wrong - China pegs

Depegged from the U.S. dollar. On 21 July 2005, the peg was finally lifted, which saw an immediate one-time RMB revaluation to ¥8.11 per USD. The exchange rate against the euro stood at ¥10.07060 yuan per euro. ... But China 're-pegged' its currency to the dollar as the financial crisis intensified in July 2008

In reply to by JIMSJOE2

Atticus Finch Free This Mon, 08/06/2018 - 13:55 Permalink

Consider that the Federal Reserve provided at least $29 trillion to the TBTF Banks at zero interest, while the whole time the national infrastructure is degrading. China used the crisis to build out infrastructure. So, when it all goes up in smoke, which country is left with worthless paper and which country has real useful things? 

In reply to by Free This

bismillah Kimo Sun, 08/05/2018 - 18:20 Permalink

There is one more choice. 

Option #4: Invade and seize Taiwan. This will give their floundering economy a needed boost. This one bold move will bring economic and political stability to the South and East China Seas.

And no nation will lift a finger to help Taiwan regardless of treaties or promises.

It will only take a few hours.  

In reply to by Kimo

Last of the Mi… Long Live The Donald Mon, 08/06/2018 - 07:00 Permalink

I've never seen China, I must put it on my bucket list. The only real fact that I know first hand about their manufacturing is the mountains of substandard crap that dot our landfills. Japan was like this after the war, something broken was usually followed with the line "Made in Japan" and a chuckle. They rose above it and became a manufacturing powerhouse, Perversely China seems to relish total destruction of all quality in their manufacturing. 

Maybe it's a socialist thingy. Make crap, sell it to the US, devalue your currency until your people live in caves, build up islands and your navy for purely offensive purposes. 

I may have something here. 

In reply to by Long Live The Donald

Tarjan Last of the Mi… Thu, 08/09/2018 - 10:06 Permalink

"I've never seen China..."

I happen to live here and urge you to see firsthand what is going on before making statements like, "Make crap, sell it to the US, devalue your currency until your people live in caves..."

China/Chinese companies can make crap or high quality; it all depends on what the foreign buyer wants. Check out a Huawei Mate 10 phone (Chinese designed and built) sometime and you will understand why Huawei has pushed past Apple as the second leading mobile phone in the market today.

 ~ 

In reply to by Last of the Mi…

Stan522 bshirley1968 Sun, 08/05/2018 - 18:29 Permalink

Were you also one of those who disagreed when I wrote the same thing concerning the EU....? Who flew to Washington DC to kiss Trumps ass and come up with a plan to compromise? 

Jean-Claude Juncker himself did that and so will China and whomever else is blustering.

Please come search me out and apologize when it happens...

Thanks......

In reply to by bshirley1968

bshirley1968 Stan522 Sun, 08/05/2018 - 18:49 Permalink

Stan, Stan, Stan....right now it is all a bunch of talk.....and lies. Place your bets and wait.

Russia has shown the way and others will follow. China's role is to ride the fence and maintain the flow for as long as possible. Europe will do what it always has. Say one thing.....do as they want.

Edit: Allow me to add documentation to my "theory".

https://www.zerohedge.com/news/2018-08-06/eu-will-keep-open-effective-f…

In reply to by Stan522

cornflakesdisease Kayman Sun, 08/05/2018 - 19:26 Permalink

$1 trillion that the FED would snap up for pennies on the dollar.

 

The handwriting is on the wall for China.  Companies are leaving in droves for greener pastures (India and Pakistan) for cheap labor, China is very difficult to deal with for a corporation with all it's government control and issues and corruption.  Having been to China several times, the country basically has no clean drinking water or breathable air.  Manufacturing is radically changing:

 

https://www.theguardian.com/world/2016/may/25/adidas-to-sell-robot-made…

 

(read that last two sentences of the article: one company pulling the plug on 1 million jobs and Nike says it plans to follow suit).

In reply to by Kayman

ultrasonic cornflakesdisease Sun, 08/05/2018 - 22:19 Permalink

That is so bullshit.  I used to live in Shanghai only a few years ago.  The water is drinkable, the air is no worse than LA and public transit is in abundance.  Meanwhile the government is increasing rapidly the use of electric cars and buses to bring down air pollution further.

 

Now that I am back in America I see this shit all the time.  Where do you guys get this stuff, Fox, InfoWars?  Why is everyone so keen on espousing on things they literally know nothing about?

In reply to by cornflakesdisease

Agent700 cornflakesdisease Mon, 08/06/2018 - 07:03 Permalink

Yeah, I don't know about that..I've lived here for 9 years and I would say the country is vastly ahead of the USA in many areas, yet still learning how to compete in others. All the debt at least bought plenty of NEW infrastructure, social improvements, military hardware and economic growth. Yes, the debt to GDP is enormous and there are PLENTY of white elephants outside my window..

But here in Shenzhen the air is clean, the sky is blue and the clouds are white. Biggest hazard here is stepping off the curb because you didn't hear the electric bus coming. The city is modern, clean and QUIETER than most. After 9 years I would also say the general education/civility of the Chinese people has improved - somewhat......

And remember - China has the Gold. They have the option of making the New Rules. Always think about the unit of account (money), and the purchasing power/global capital flows that a hard currency jurisdiction would attract.

In reply to by cornflakesdisease