In a surprisingly candid assessment, a prominent Chinese economist and former central banker warned on Saturday that China should be prepared for a new round of capital outflows and currency depreciation when bracing for the impact of the trade war with the US and other disturbances to the financial markets.
Yu Yongding, a senior researcher with the Chinese Academy of Social Sciences and a former adviser to the People’s Bank of China, said "some disturbing factors" had emerged in the Chinese financial markets, such as the wave of peer-to-peer lending defaults which we discussed over the weekend, as well as renewed concerns about a property bubble and an economic slowdown in the second half of the year.
As the SCMP first reported, Yu told a financial forum in northeastern province of Heilongjiang that the trade war with the US will have a negative impact on China’s economy and market sentiment, as will the impact of interest rate increases in the US and the financial crisis in emerging markets.
Yu also warned of the risks of the plunging Turkish lira after US President Donald Trump doubled steel and aluminium tariffs on Turkey amid ongoing political tensions. The lira, which has continued to tumble on Monday, and is the worst performing currency of 2018, also took its toll on the European financial markets, weakening the euro and rouble.
“There have been discussions among investment bankers whether there would be a repeat of the Asian Financial Crisis. The so-called herd effect [like that] in the  Asian financial crisis may affect China,” he said.
Putting these growing adverse factors together, Yu warned that the yuan exchange rate would continue to face "downward pressure which may reinforce the depreciation expectations”.
“I think maybe we should be prepared for a new round of capital outflow and yuan deprecation. This may not happen, but we should prevent the problems before they happen,” he said.
And speaking of devaluation, Saturday marked the 3rd anniversary of the PBOC's decision to devalue the Yuan in 2015. The central bank engineered a depreciation of 2% in three consecutive days starting on August 11, 2015, but insufficient communications with the market triggered panic and launched continuous capital outflows amid fears of an economic slowdown.
Then confirming what we recently wrote, namely that China's Achilles heel is its capital control firewall...
China faces capital outflow pressure as future uncertainties grow, says Guan Tao, a former official at State Administration of Foreign Exchange: BBF— zerohedge (@zerohedge) July 29, 2018
China’s Achilles heel is its capital controls
... Yu advised the authorities to check "carefully" any possible channels or loopholes for huge capital outflows and also prevent digital currencies from being leveraged as a new tool for the capital exodus: i.e. prevent bitcoin from once again becoming the preferred medium of capital flight from China's financial system which at last check had nearly $40 trillion in deposits.
"The government has done quite well and is very sophisticated in managing cross-border capital flow," said Yu, although that may well change if there is another Chinese economic crisis.
Shifting focus on the ongoing trade war with the US, the PBOC said in its quarterly monetary policy report on Friday that China would not use currency devaluation as a defensive weapon to counter the turmoil of the US trade war, even though many have suggested that China is doing precisely that, if for no other reason than by not intervening to prevent the sharpest monthly slide on record in the Yuan.
The central bank also warned that the trade war would hit exports and possibly market sentiment and could exacerbate turbulence in the financial markets.
As a result of rising trade tensions and slower economic growth, the Chinese currency has continued to test the key 7.0 level against the US dollar since last month when it saw a strong wave of depreciation. Last week the central bank moved to raise the costs of foreign exchange speculation to prevent the yuan’s further sliding, and while the Yuan initially rose on the report, it has since fully faded that move.
But Yu said it was “irrational that everyone is obsessed with a particular number” and said there was no difference whether the dollar exchange rate was 7 or 6.9. Well in that case, the PBOC should have no problems letting the currency drop some more if it is only "round numbers."
“It seems the central bank could send a signal to the market that it is not its goal to defend the yuan above 7 against the dollar” said Yu, who ruled out the likelihood of a massive depreciation of the yuan.
As the SCMP concludes, Yu suggested the central bank should improve its communications with the market to appease market sentiment but continue to refrain from regular market intervention. Because the one thing that the world needs is more "data dependent" failed forward guidance, this time from China. Although with its economy micro managed and goalseeked to the smallest variable, at least the central bank should have no problems hitting its economic benchmarks.