Thursday, January 14, 2016

What Will China Dump Next, to Keep Control?.....

What Will China Dump Next, to Keep Control?

Beneath all of the financial turbulence there lurks, a global credit crisis. The reform agenda has stalled, and "things are looking much bleaker for China going forward.

The Shenzhen Composite is down 30% from its April 2015 high.

Everyone had hoped that China's "National Team" would jump into the fray and bail everyone else out, but it didn't. And the People's Bank of China didn't offer any big new remedies either.

So what is China going to dump next?

In the next two months I would still say Treasuries. But if the pressure continues beyond that, it's non-US assets, and in the US space it's definitely corporates and agencies.

China still holds:

$1.29 trillion of Treasuries
$1.15 trillion of non-US assets (mostly short-dated euro-denominated bonds)
$212 billion of US agency debt
$415 billion of US corporate bonds,
$266 billion of stocks.

Selling a significant part of its $415 billion of US corporate bonds and $266 billion of stocks will likely leave an imprint on the markets. And selling $500 billion or more in assets a year when the total stash is down to $3.3 trillion, well, pretty soon it becomes apparent that this cannot be done for a long time before markets realize that it cannot be done for a long time, and then, when confidence collapses, things could get a little hairy.

By dumping its FX reserves, China is trying to counteract the impact of capital flight. Fitch Ratings reported today that capital flight since the second quarter of 2014 is by now "likely to have exceeded" $1 trillion. In light of that kind of number, those $3.3 trillion of foreign exchange reserves don't look that huge.

The causes of these capital outflows have grown more numerous and "have entered a new phase" in the second half last year, broadening to include foreign direct investment and portfolio instruments, something that could make future capital outflows practically boundless.

China is facing a sharpening dilemma between a perceived need to keep interest rates low to help the economy manage its debt burden, and downward pressure on the Chinese yuan and foreign reserves.

The authorities have reduced interest rates steadily since November 2014 in a bid to help the economy manage its debt burden – which is high and still rising – at a time of slowing growth. However, lower rates are helping to drive capital outflows, weakening the yuan.

So China is selling its FX reserves to prop up the yuan. But….

A country cannot simultaneously allow free capital flows and control its exchange rate and domestic interest rates. This is at the core of the policy dilemma China faces between the imperative of keeping rates low for domestic stability against pressures on external stability as exemplified by the exchange rate and reserves data. China still operates capital controls, but the scale of flows suggests that these have become porous.

And that coming massive yuan devaluation everyone is talking about? Maybe not. Because it might just be the trigger that would set off a nasty chain of events:

Fitch does not expect the authorities to resolve the dilemma with a large trade-weighted yuan depreciation, as this would risk creating additional uncertainty and further undermining policy credibility….

Because "policy credibility" is sacrosanct. Losing it would be the nightmare scenario. It would signal to the markets that the authorities have lost control entirely over the currency, the credit markets, the stock markets, and all the things they've been trying to keep from unraveling. And this would start the unraveling in earnest.

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