Is Chinese capital flight upon us?

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More today on a recurrent them at MB about what level of risk China will face as its external dollar-funding dries up. I’ve previously noted the BIS report on the issue and more reassuring material from last week from Nomura. Now we have a new twist from Ambrose Evans-Pritchard, this time around the carry trade:

Three of the world’s largest banks have warned that the flood of “hot money” into China is at risk of sudden reversal as the yuan weakens and the US Federal Reserve brings forward plans to raise interest rates, with major implications for global finance.

…They argue that China’s credit boom has become a “function” of external dollar funding, mostly through offshore lending in Hong Kong and Singapore to circumvent internal curbs. It is a powerful side-effect of super-loose policies by the Fed, which the Chinese have been unable to control. If so, this may snap back abruptly as dollar liquidity dries up and fickle money returns to the US.

Bank lending to emerging markets has surged by $1.2 trillion (£720bn) over the last five years to $3.5 trillion. The banks have funded most of these loans from short-term sources, leaving the whole nexus extremely vulnerable as the US prepares to tighten. The Fed caught markets badly off guard earlier this month when it suggested that interest rates would jump from near-zero to 1pc next year and 2.25pc the year after, a much faster pace than expected.

Half of this foreign lending is linked to China, where dollar loans have jumped by $620bn since 2009. Roughly 80pc are at maturities of less than one year. The report warned that higher rates might “erode bank’s willingness to roll over their cross-border loans to borrowers in China”.

Nomura issued a client note on Friday warning that the carry trade is “reversing gear”, describing a break-down of discipline in which almost everybody in China from investors, to manufacturers, exporters, and commercial banks have been playing the game. Most of the borrowing has been in dollars and yen on the Hong Kong market.

Wendy Liu, Nomura’s China strategist, said investors are putting too much hope in the promise of fresh stimulus and infrastructure spending, ignoring the risks of a weak yuan.

She said devaluation is a double-edged sword. It helps cushion the shock of China’s economic slowdown, boosting “the razor-thin margins” on exporters along the Eastern seaboard. It may also mitigate the “coming wave of credit defaults”. But is also exposes the fragility of the system. A view is gaining credence that the weak yuan is an early warning sign that “China’s credit bubble may implode imminently”, she said.

I wouldn’t go that far. The PBOC has engineered this shift in the carry trade. Capital is not flooding out because of a loss of faith in the system but because the PBOC has deliberately injected doubts about the one way bet on a rising yuan. Genuine capital flight won’t happen unless China has a substantial credit event (which I guess is coming in the next 18 months).

But there is no doubt that this line of reasoning supports my basic contention about China intends to keep both the brake pedal and accelerator planted simultaneously, resulting in restructuring not another boom. We’ll get more fiscal stimulus but the PBOC wants to keep credit tight to shake out the ponzi borrowers in property, steel etc.

An elegant solution, until a large enough entity goes under…

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.