China is walking on a tightrope as foreign funds exit
The Chinese yuan has fallen to the lowest level this year against the US dollar after the People’s Bank opened the monetary spigot to avert an economic slowdown.
It raises the spectre of capital outflows and a potential currency scare akin to late 2015 if the dollar keeps rising.
The slide in the yuan exchange rate over recent days comes as global investors start to vote with their feet, no longer viewing China as a “safe haven” impervious to trouble sweeping other emerging markets.
The currency has been falling since April but the pace has picked up sharply, weakening by almost 3 per cent to 6.55 against the dollar over the last seven trading sessions. It is a large move for a carefully managed currency, comparable to the sort of shift that set off trouble in 2015.
Hans Redeker, currency chief at Morgan Stanley, said the latest fund data shows that foreigners are liquidating investments in Chinese assets made in the last year through the Shanghai-Hong Kong Connect.
“A significant amount of money went in (US$80b), and now it is coming out again. The big currency moves we have seen recently are foreign outflows from China through ‘Connect’. The scale is nothing like 2015 because the capital account is closed, but China is seeing some of the emerging market syndrome,” he said. The People’s Bank cut the reserve requirement ratio (RRR) for banks by 50 basis points to 15.5 per cent last weekend, injecting over US$100b of liquidity into the financial system. It is different from an earlier reduction in April, carried out for technical reasons.
“The RRR cut is a clear sign of policy easing amid strong headwinds. We believe the Chinese economy has yet to bottom out, and the situation could worsen before getting better,” said Ting Lu and Wisheng Wang from Nomura.
While the RRR cut happened to coincide with the escalating tit-for-tat trade war with US, it had far more to do with concern over rising default rates and the slump in business investment.
“The bigger threat to China’s economy this year has always been the delayed impact of last year’s policy tightening,” said Capital Economics.
Last week the PBOC announced the creation of a special “financial risk tracking unit” to monitor local and global conditions after a surge in corporate defaults. Beijing is quietly orchestrating a rescue for HNA Group, saddled with US$94b of debts. The Shanghai Composite index of equities has fallen to a two-year low of 2859.
Simon Ward from Janus Henderson says the growth rate of the M1 money supply has plummeted to 6 per cent from a 25 per cent peak in mid-2016 when the central bank opened the floodgates.
“Monetary trends are unambiguously weak,” he said.
Nomura said it expects a blast of easing measures over coming months. These include a further 100 point cut in the RRR, higher commercial bank quotas, and a fiscal boost for local governments.
The risk for China is the central bank is loosening just as the US Federal Reserve tightens hard to head off incipient inflation in the US economy. The Fed has sketched a faster pace of rate rises. It is also draining global dollar liquidity relentlessly, with plans to reverse quantitative easing by US$50b a month from September onwards.
The hawkish US policy is pushing up the US dollar. This creates a toxic dilemma for the Chinese. If they loosen policy too much to shore up their economy, they risk a slide in the yuan, unsettling Chinese investors and triggering capital outflows.
The experience of 2015-2016 showed this can get out of hand. The exodus reached US$100b a month.
The PBOC ran through a quarter of its US$4 trillion of foreign exchange reserves. The trauma is seared in the memory of China’s economic leadership. It is why Beijing is extremely unlikely to devalue the yuan as a way to retaliate against President Trump’s trade tariffs.
“They will absolutely not think of doing that,” said Geoffrey Yu from UBS, son of a former PBOC rate-setter.
The China currency scare two years ago ended when the Yellen Fed came to the rescue and suspended its tightening cycle, buying precious time for the Chinese authorities to restore control and launch a fresh mini-boom. The circumstances are entirely different today.
The US is closer to overheating. The Powell Fed is more hawkish. The Trump Treasury will not lift a finger to help this time.
China risks finding itself caught between a rock and a hard place, or facing an “Irreconcilable Duo” in economic argot.
While it is unlikely the country will have to tighten “pro-cyclically” into a downturn it may well find that it cannot loosen much either without risking a currency crisis. The PBOC is walking a tightrope.