China can’t stop currency outflow

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Cross posted from Investing in Chinese Stocks

Bloomberg: SocGen: Half-Hearted Capital Controls Are Coming to China

Société Générale China economist Wei Yao thinks Chinese policymakers will take a measured approach to solving this conundrum—allowing the currency to depreciate in a controlled manner while placing more restrictions on the flow of capital out of the country.

Yao notes that in this discussion, it’s important to distinguish which variable is the dog and which is the tail.

“The total size of capital outflows, among other factors, is mathematically a function of the PBoC’s choice of currency policy, not the other way around,” she writes. “That is, total capital outflows equal the current account surplus plus the amount of FX reserves that the PBoC is willing to sell based its target for the RMB relative to the market’s view.”

The largest source of capital outflows over the fourth quarter of 2014 and first quarter of 2015 has been declines in loan and trade financing liabilities by China’s corporate sector, with the majority of those flows attributable to debt deleveraging.

It would be better to call them half-assed capital controls. Yao goes on to note the massive hole that is “errors and omissions,” which shows capital is finding ways out the country. Chinese exporters can hoard dollars in Hong Kong or other offshore banking centers. Chinese and foreigners alike can buy art, gold, property and other high value items as a way to exit the yuan, even if the asset in question never leaves the shores of China. Once expectations of depreciation set in, people will find a way out of the yuan. Finally, there’s the offshore yuan which can act as a perma-drain on reserves if it consistently trades below the onshore price.

“Not letting the currency go requires significant FX intervention that will not prevent ongoing capital outflows but which will result in tightening domestic liquidity conditions; but letting the currency go risks more immense capital outflow pressures in the immediate short term, external debt defaults and possibly further domestic investment deceleration,” says Yao.

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The solution to this problem is a massive one-off devaluation. China did it in the 1990s and experienced 15 years of rapid growth, plus 5 more thanks to the post-2008 stimulus.

Currency devaluation is not a solution. It is the denouement of rapid credit inflation. Given the choice between deflation and devaluation, governments will choose devaluation. Given the behavior of China’s government with regards to the stock market crash, I don’t think their pain tolerance is as high as people think.

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China has depreciated the value of the yuan again, by restricting its usefulness in financial transactions, raising the cost of hedging and speculating on currency volatility. These types of moves usually fail to stop the trend and this move only represents a small speed bump. Well worth paying if an investor or speculator expects further depreciation.

Bloomberg: China Orders Banks to Hold Reserves for Currency Forwards

The People’s Bank of China will impose a reserve requirement on financial institutions trading in foreign-exchange forwards for clients, according to six people familiar with the matter. The change, which takes effect on Oct. 15, will mandate a deposit of 20 percent of sales to be held at zero interest for a year, said the people, who asked not to be identified because they aren’t authorized to speak on the issue.

“It’s a move to ease the reduction in foreign-exchange reserves,” said Tommy Ong, managing director for treasury and markets at DBS Bank Hong Kong Ltd. “It’s also meant to discourage speculation and ensures the yuan’s rates are reflecting genuine demand and supply. That includes cross-border yuan investment into fixed assets.”

Reducing financial speculation is a noble goal, but it requires moving towards something like a gold standard. China controls the price of the yuan, but the structure of its own currency, like that of the global financial system, is a floating currency. The volatility cat is out of the bag and putting it back will be almost impossible.