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:
- intervene in currency markets to offset market pressures risking a new wave of reserve depletion;
- raise interest rates to defend the currency causing monetary tightening and risking economic weakness; or
- 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.