Sunday, August 23, 2015

China's Massive Capital Outflows

China's Currency Devaluation Shocks The World!
China looks to be in for an extremely bumpy ride as a lot more investors question the risk of holding yuan assets. For years credit has expanded rapidly in China, and now much of the country is mired in debt. A big question is how much of this credit expansion was built on foreign capital flowing into the country as Beijing pursued a strong yuan policy pegged to the U.S. dollar. Since 2005 the yuan has appreciated about 30%  profiting those who put money in China. The  general consensus held by everyone from deposit holders in Hong Kong to high-yield-bond investors in Europe was this would continue. Over the years this has pushed along the misallocation of credit on a grand scale and continued the build-up of bad assets in the banking sector. The county's surprising and bold move to devalue the currency is very important and problems resulting from the unwinding of these capital inflows have the potential to further destabilize China which is already in financial turmoil. 

An estimate by Goldman Sachs has indicated China might be facing credit losses of as much as $3 trillion as defaults ensue from the expansion of the past four years, particularly by non-bank lenders such as trusts, this far exceeds amounts seen in prior credit crises. It is important to note the events unfolding in China and the resulting fallout may continue for some time within the country of  about 1.4 billion people that is responsible for the world's second largest GDP, also a risk of contagion exist that will be felt across the world. A great deal of the hot money that flowed into China is now exiting, this and a slowing economy has resulted in the rapid rise in the ratio of credit to GDP. That measure has moved from 120% in 2007 to around 180% at the end of 2012. Interest owed by borrowers rose to an estimated 12.5 percent of China’s economy from 7 percent in 2008, Fitch Ratings estimated in September. By the end of 2017, it may climb to as much as 22 percent and “ultimately overwhelm borrowers.” It is possible China’s total credit will be pushed to almost 250 percent of GDP then or more than double the 120 percent figure of 2007.

Data released last week for July confirms China is experiencing massive capital outflows. A surge in these monthly outflows made it the biggest since 1998 with foreign-exchange funds held at Chinese banks falling by 249.1 billion yuan ($39 billion). Some sources suggest the capital outflows from China have grown to as high as $190 billion over the last seven weeks forcing the authorities to intervene. Yang Zhao from Nomura claims $90 billion left the country in July with the pace accelerating since the People's Bank Of China (PBOC) shocked the markets by ditching its currency peg to the U.S. dollar. Capital flight for the first three weeks of August is already close to $100 billion despite the draconian use of anti-terrorism and money-laundering laws to curb illicit flows. Another sign of stress is the rise last week in short-term borrowing rates in the inter-bank markets of both China and Hong Kong. This again is a sign investors are fleeing the yuan, the rate jumped 1,380 basis points over the last week to 1.667% reaching near a four month high.

While some explain last week’s surprise yuan devaluation as little more than an overdue step toward a market-determined exchange rate it is more likely China's central bank changed its policy as a last resort. Pressure has mounted recently from several events and the the pain of attempting to hold its currency peg to the U.S. dollar finally became unbearable. We must remember Beijing is being hit by the perfect financial storm as forces from a closed capital account, independent monetary policy, and a tightly managed exchange rate all have decided to plummet the economy at the same time. The capital outflows have  ratcheted up the pain forcing an already beleaguered PBOC to support its currency peg. This is at a time that it removes badly needed liquidity from the economy just as the authorities seek to provide support and a floor under the sagging stock market.

Currently, the PBOC is under tremendous pressure as the responsibility of holding this mess together rest solidly on their shoulders. A massive scheme for the state to buy stock shares to halt a falling market while dealing with near bankrupt municipal authorities is only part of the woes they face. Too many who question the stability China's economic foundation this will only delay the day of reckoning. Only weeks ago they strong armed the state banks into buying over $313 billion dollars worth of debt swap bonds in an effort to keep municipal authorities afloat, this most likely will leave the central government taking the hit down the road. The assault of currency outflows comes on the back of two significant setbacks supporting the worlds confidence in yuan assets. In June Chinese shares failed to be included in the MSCI Emerging Markets benchmark Index, this was followed by news Beijing will need to wait at least another year before the yuan can be considered for inclusion as an International Monetary Fund reserve currency.

All this plays into an overall deterioration that makes it logical for many investors to get out of the yuan and it must be noted as this wealth flees for safety it must go somewhere. I contend that bumps in currencies such as the yen, euro, and pound are indications this "wealth" leaving China and I expect much of it will take the scenic route to America. The smaller the currency the more money flowing into it is noticed and when money moves out of China it must often "leak" out through quiet and well established channels to avoid notice by the authorities. A key factor determining which currency to funnel your money into is which you currently consider most undervalued, but sooner rather than later I suspect it will be placed in the dollar which is the most liquid and by many considered the cleanest dirty shirt in the closet. 

 Footnote; Please feel free to explore the blog archives and as always you comments are encouraged. For more on China see any of the post below,

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