By CRAIG STEPHEN at Marketwatch
Among the many unknowns in China is just how much of its prodigious credit boom has been built on foreign capital. After last week’s high-stakes gamble to devalue the yuan, we may soon find out.
So much investment and hot money had bought into Beijing’s flagship policy of a strong yuan pegged to the U.S. dollar — which has appreciated DXY, +0.19% about 30% since 2005 — that this reversal moves into almost uncharted territory. By shattering a 10-year consensus held by everyone from deposit holders in Hong Kong to high-yield-bond investors in Europe, the unwind in capital flows could be of seismic proportions.
See: The proof that U.S. markets care more about China than about Greece
While some explain last week’s surprise yuan devaluation as little move than an overdue step toward a market-determined exchange rate, a more plausible interpretation is that the People’s Bank of China jettisoned its exchange rate policy as a last resort; a culmination of events after which the pain of attempting to hold its currency peg to the U.S. dollar finally became unbearable.
This scenario would be supported by data released last Friday for July, showing the biggest monthly surge in money outflows since 1998 as foreign-exchange funds held at Chinese banks fell by 249.1 billion yuan ($39 billion).
Meanwhile, another sign of stress is that short-term borrowing costs in the interbank markets in China and Hong Kong spiked last week, suggesting again that investors were pulling out of the yuan. The overnight Shanghai interbank offered rate (or Shibor) leapt 1,380 basis points to 1.667% over the past week, reaching a near four-month high, and the one-month Shibor jumped to 2.495%, a one-week high.
For some time Beijing has been under pressure to hold together the “impossible trinity” of a closed capital account, independent monetary policy and a tightly managed exchange rate. Capital outflows ratchet up the pain as the central bank has to buy yuan to support the peg and withdraw liquidity from the economy.
This was difficult enough when authorities have been attempting to provide sufficient liquidity to put a floor under a foundering economy. But then the stock market rout heaped further pressure on the PBOC as it was given ultimate responsibility, through a massive state-buying scheme, to also keep shares from falling.
If this wasn’t enough, the central bank had just pushed the problem of near-bankrupt municipal authorities out of its in-tray. Weeks earlier the central government had strong-armed state banks into buying 2 trillion yuan’s worth of debt swap bonds designed to refinance broke municipal authorities.
It is hardly a stretch to state that with the central government lining up to be on the hook for municipal authority debt and stock-market losses, this deteriorating picture would persuade some investors to get out of yuan.
These foreign-currency outflows also come as Beijing has suffered two significant setbacks to support international confidence in yuan assets. In June Chinese shares failed to be included in the MSCI Emerging Markets benchmark Index. Last week Beijing learned it will need to wait at least another year before the yuan can be considered for inclusion as an International Monetary Fund reserve currency.
Since 2007 and the global financial crisis, indications are that China has become much more reliant on international funds, despite still officially operating a closed capital account.
This period has coincided with not just yuan appreciation but the Federal Reserve’s quantitative-easing program, which helped direct abundant hot money to China. One of the drivers of the massive growth in China’s shadow banking was global capital seeking the higher returns on offer. And a strong and appreciating currency was crucial to attracting capital.
This stood out during the 2013 taper tantrums, as, while much of the rest of Asia was suffering currency weakness and capital outflows, China was spared. In fact, due to the conviction behind its policy-driven exchange rate, the yuan was actually seen as a safe haven.
Capital also flowed into China, as quantitative easing by Japan added to carry-trade borrowing in U.S. dollars or Hong Kong dollars into the mainland. The stability of the yuan also contributed to a boom in offshore high-yield-bond funding by Chinese corporates as investors clamored for yield.
Now with this initial yuan weakening, together with the fact that the U.S. central bank is set to raise interest rates, the conditions look set for this big carry trade into Chinese assets to unwind.
Even after last week’s small devaluation, analysts are already highlighting how much things have changed. Julius Baer commented that its call to buy offshore renminbi bonds was partly based on the low volatility in the USD/CNH cross, but this argument can no longer be maintained. In fact total returns in the last two years have been wiped out in U.S. dollar terms in just two days, based on the HSBC Off-Shore Renminbi Total Return Index.
China looks to be in for an extremely bumpy ride as a lot more investors question the risk of holding yuan assets.