I had been meaning to write about this earlier, but I didn`t find the time. Kyle Bass caused a stir last week with his letter to his investors when he wrote that China was on the verge of a major devaluation and financial blow-up (via Valuewalk):
Our research suggests that China does not have the financial arsenal to continue on without restructuring many of its banks and undergoing a large devaluation of its currency. It is normal for economies and markets to experience cycles, and a near-term downturn that works to correct the current economic imbalances does not qualitatively change China’s longer-term growth outlook and transition to a service economy. However, credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world. What we are witnessing is the resetting of the largest macro imbalance the world has ever seen.
Then on the weekend, PBoC Governor Zhou Xiaochuan said in a Caixin interview that claimed that everything was fine and there was no basis for continued CNY devaluation. In response, CNYUSD rallied by 4.5% on Monday, which was the biggest move since 2005.
What’s the real story? How serious is the capital flight problem in China and what’s the likelihood of a major Chinese devaluation?
Kyle Bass: All roads lead to devaluation
Let’s start with the Kyle Bass letter. He began by exposing in detail the severe imbalances and debt buildup in China, a problem that is well known. China’s USD 3.3 trillion may not be enough to insulate her from the coming storm, according to Bass. Firstly, Chinese foreign exchange (FX) reserves has been dropping dramatically and peaked at USD 4.0 trillion in June 2014. As well, the IMF estimates that, for a trading nation like China, minimum reserve adequacy is USD 2.7 trillion, which is not that far off the current level of USD 3.3 trillion given the rate of decline of USD 100 billion per month.
Bass further made adjustments to the USD 3.3 trillion, based on the availability of funds, and concluded that current FX reserves is actually below the magic USD 2.7 trillion deemed adequate by the IMF.
Bottom line, Beijing has few options left. None of them are good:
- Cut interest rates to zero and let the banks “extend and pretend” bad loans – lower interest rates will force more capital abroad putting downward pressure on reserves and the currency.
- Use reserves to recapitalize its banks – this will reset the banking sector, but wipe out the limited reserve cushion that China has built up, and put downward pressure on the currency.
- Print money to recapitalize its banks – this will reset the banking sector, but the expansion of the PBOC’s balance sheet will lead to downward pressure of the exchange rate.
- Fiscal stimulus to revive the economy – this will help some chosen sectors of the real economy, but at the expense of higher domestic interest rates (if not done in conjunction with Chinese QE). The 2009 fiscal stimulus was primarily executed through the banking sector so a similar program would require a properly capitalized banking sector. Also, any increase in Chinese investment would reduce China’s trade surplus and ultimately pressure the currency.
Not as bad as it looks
- The strong USD effect on FX reserves;
- Chinese entities paying down USD denominated external debt;
- A reversal of speculative hot-money inflows;
- Hedging; and
- Actual capital flight.
Since China is still notionally a communist country and notionally a command economy, one possible remedy suggested by Concentrated Ambiguity is to force Chinese companies to repatriate their profits from abroad (imagine what that would do to the likes of Apple and the US fiscal position). Dan Harris at China Law Blog reports that some heavy handed implementation of administrative measures are already taking place and it is very difficult to get money out of China these days:
Well if there is a common theme, it is that China banks seem to be doing whatever they can to avoid paying anyone in dollars. We are hearing the following:
1. Chinese investors that have secured all necessary approvals to invest in American companies are not being allowed to actually make that investment. I mentioned this to China attorney friend who says he has been hearing the same thing. Never heard this one until this month.
2. Chinese citizens who are supposed to be allowed to send up to $50,000 a year out of China, pretty much on questions asked, are not getting that money sent. I feel like every realtor in the United States has called us on this one. The Wall Street Journal wrote on this yesterday. Never heard this one until this month.
3. Money will not be sent to certain countries deemed at high risk for fake transactions unless there is conclusive proof that the transaction is real — in other words a lot more proof than required months ago. We heard this one last week regarding transactions with Indonesia, from a client with a subsidiary there. Never heard this one until this month.
4. Money will not be sent for certain types of transactions, especially services, which are often used to disguise moving money out of China illegally. This is not exactly new, but it appears China is cracking down on this. For what is ordinarily necessary to get money out of China for a services transaction, check out Want to Get Paid by a Chinese Company? Do These Three Things.
5. Get this one: Money will not be sent to any company on a services transaction unless that company can show that it does not have any Chinese owners. The alleged purpose behind this “rule” is again to prevent the sort of transactions ordinarily used to illegally move money out of China. Never heard this one until this month.
It`s not you, it`s me
Putting it all together, what do we have? Of the approximately USD 700 billion in “capital flight”, about USD 400 billion is benign, accounted for by a falling euro and Chinese corporations paying down their USD external debt. The remaining USD 300 billion can be explained by a combination of the reversal of hot money flows, trade flows and actual “capital flight”.
Even the term “capital flight” has highly negative connotations, but how real is that? One man’s capital flight is another man’s portfolio diversification. Could this all be a tempest in a teapot?
We have all heard about the phrase “it’s not you, it’s me” in a relationship breakup. Is falling CNYUSD reflective of capital flight out of China, or just a strong USD? The chart below shows that the trade-weighted Yuan has been fairly steady since March 2014.