Thursday, March 19, 2015

Searching for China's (financial) WMDs

I got a lot of feedback from my post last week on the effects of Chinese capital flight on the Vancouver property market (see Behold the tsunami of liquidity from China). While there were a few locals who had comments about the local real estate market, the majority of comments had to do with the risk of a RMB devaluation.

It seems that the issue of a CNY devaluation is a hot topic these days. Let me make this clear from the beginning. When I refer to a Chinese devaluation, I don't mean run of the mill operations like a RRR or interest rate cut, but a massive shock-and-awe effort like a QE program or an explicit announcement to widen the allowable CNY trading band. Such moves would send massive shockwaves around the financial world.

There has been no lack of warnings about the pressures on China as the latest round of economic weakness is highly suggestive of another round of stimulus. Even Xinhua, China's official news agency, raised concerns about currency pressures on Chinese exports:
The pressure is on Chinese exports as the euro sinks against the yuan, Ministry of Commerce spokesman Shen Danyang said on Tuesday.

The yuan was up 10.8 percent against the euro until March 13, when the euro devalued 13.2 percent against the U.S. dollar.

The price advantages of Chinese exports to the European market has been softened by the euro devaluation, said the spokesman. The weak euro will also incite eurozone exports to other markets, adding competitive pressure to China's high value-added exports.
The WSJ rhetorically asked, "Will China Break the Currency Truce?"
In the past five years, first the dollar, then the yen, and now the euro have tumbled as their respective central banks have undertaken large-scale bond-buying, or “quantitative easing” (QE). This is not a zero-sum currency war: QE sends money cascading across borders, bolstering asset markets and often triggering reciprocal monetary easing. Everyone wins.

But it’s a different matter if China devalues; that would kick off a currency war.
That's because a Chinese devaluation would amount to the detonation of a financial WMD, aimed at the heart of the economies of its major trading partners.
China is different because, even after significantly liberalizing its financial system, it still maintains controls over how much money can move in and out. When interest rates rise or fall, foreigners and residents can’t respond by moving money at will in and out of China, except surreptitiously. A repressed financial system means China has multiple tools for multiple targets: interest rates and credit guidance to target investment; reserve requirements to target bank liquidity; and the yuan to target trade.

This means that when China’s currency falls, its trading partners don’t get the usual benefits of easy monetary policy; there is no outrush of capital from China to other countries, and no boost to domestic spending to bolster imports.

That is why a move by China to devalue would arouse much more tension with its trading partners than the QE-driven devaluations by the U.S., Japan and eurozone. Whether that will happen is a matter of fierce debate.
In my previous post, I highlighted the analysis by David Woo of BoAML about a potential currency war and FX volatility (via Business Insider). Such volatility episodes have been associated with market turmoil in the past.

As the chart shows, the effects of a RMB devaluation would indeed look like a financial WMD.

How likely is a Chinese devaluation?
If I were a goldbug, or if I wrote for Zero Hedge, I would stop right here. The tail-risks are obvious and, while we have no way of knowing when Beijing devalue, disaster is just around the corner.

A more intelligent analyst might try to ascertain if China did possess such financial WMDs and, if they do, what the likelihood that the PBoC might use it.

Staying with the WMD analogy for the moment, suppose that you were an intelligence analyst and your job is to figure out if a certain country had WMDs. What would you do?

Modern military organizations are bureaucracies (as are finance ministries and central banks). ABC (Atomic-Biological-Chemical) warheads are volatile and difficult to handle. Moreover, their use can carry enormous political risk. The last thing you want is for some rogue officer to drag your country into a war you didn't start by firing off one of these weapons. Therefore the standard procedure is to create policies and procedures for the storage and release of these ABC weapons. Typically, one group of troops guard and store the warheads; and another delivers them.

As an example, I once spoke to a former Canadian Starfighter pilot who was stationed in Germany in the 1960s. He was part of a Starfighter squadron whose mission was to drop nuclear warheads on the advancing Soviet forces should war break out. The aircraft (delivery vehicle) was under Canadian control, but the warheads were under American control. Part of the procedure was the plane would sit, with the nuclear bomb attached, on alert on the tarmac.

One of the key failsafe procedures was that the Canadian pilot had to sit in the cockpit with the canopy open with both hands visible at all times holding the side of the fuselage. An armed American guard stood nearby, with orders to shoot the pilot should he move his hands inside the cockpit.

Who would get hurt should China devalue?
In the same spirit, we can look for possible policies and procedures that the PBoC may undertake should they decide to devalue the RMB.

We know that there are lots of reasons why Beijing might want to devalue, but there would be considerable damage done too, both to their economy and the economies of their trading partners. While the PBoC might not care about White People getting hurt, nor would they care very much about the Japanese, Koreans, Singaporeans and so on, they would care about the pain suffered in Hong Kong and by Mainland Chinese companies.

Marketwatch recently devoted an article about the vulnerabilities of Hong Kong should China devalue:
Hong Kong began the Lunar New Year with its chief executive imploring the population to be more like sheep. But investors should watch where they are being led: As currency wars threaten to engulf its giant neighbor and spur it to devalue the yuan, Hong Kong looks highly exposed.

Attention in recent weeks has focused on the possibility of yuan depreciation as China’s economy slows and as it suffers capital outflows.

It is worth considering the fallout for Hong Kong under such a scenario, given the extent to which its economy has become dependent on the supercharged stimulus of an artificially suppressed currency.
The Achilles Heel of Hong Kong is the Hong Kong Dollar and its USD peg, which has spawned a currency and interest arbitrage carry trade (emphasis added):
Analysts have been sounding the alarm over the growth of a huge “invisible carry trade” of lending into the Chinese mainland in recent years.

As China’s currency appreciated, borrowing in Hong Kong dollars became extremely popular, not only because of the much lower interest rates than on the mainland but also due to the attraction of taking out a liability in a depreciating currency. The kicker would come from sticking this money into high-yielding shadow-banking products.

Brokerage Jefferies was flagging this a year ago, describing an almost parabolic increase in lending to mainland China.

Bank of America echoes such concerns in a recent report, detailing how lending exposure has reached 160% of Hong Kong’s entire gross domestic product, up from 20% in 2006. It cautions that instability and imbalances can be caused by currencies that have been on a predictable, stable trajectory, fomenting the belief that the trend will be permanent.
Bloomberg recently highlighted a BIS report indicating that while Chinese USD offshore liability growth had slowed, total Chinese USD liabilities amounted to USD 1.1 trillion:
U.S. dollar-denominated borrowing by companies in Asia was fueled in recent years by lower interest rates and abundant liquidity offshore. Now, as the Federal Reserve prepares to raise interest rates and the greenback strengthens, heavily indebted companies face the prospect of higher repayments.

“The growth of claims on China by BIS reporting banks slowed down sharply,” Claudio Borio, the BIS’s head of the monetary and economic department, told reporters. “The possible turn in domestic financial cycles as U.S. dollar funding is set to tighten deserves close watching.”

Dollar credit to Chinese borrowers has reached $1.1 trillion, the BIS said in a January report. Asia’s largest economy has the world’s biggest corporate liabilities that Standard and Poor’s estimates stood at $14.2 trillion in 2013.
In another words, there has been an enormous “invisible carry trade” where Mainland Chinese companies either borrow in HKD or USD in Hong Kong at lower interest rates, move the funds back into China and invest the proceeds into shadow banking products at mid to high single digit interest rates. A simple devaluation would blow an enormous financial hole in the Chinese financial system as the value of those liabilities skyrocketed. Moreover, it would crater the Hong Kong financial system, as the lending exposure of 160% of GDP is comparable to the exposure of Cypriot banks at the start of their financial crisis.

Beijing will have to tread carefully in formulating RMB devaluation policy and procedures. Bloomberg wrote about the kinds of risks faced by EM economies, especially as the Fed enters a tightening cycle. While Chinese USD debt amounted to USD 1.1 trillion, total offshore USD debt was 9 trillion. These issues were raised at the last G20 meeting (emphasis added):
When Group of 20 finance ministers this week urged the Federal Reserve to “minimize negative spillovers” from potential interest-rate increases, they omitted a key figure: $9 trillion.

That’s the amount owed in dollars by non-bank borrowers outside the U.S., up 50 percent since the financial crisis, according to the Bank for International Settlements. Should the Fed raise interest rates as anticipated this year for the first time since 2006, higher borrowing costs for companies and governments, along with a stronger greenback, may add risks to an already-weak global recovery.

The dollar debt is just one example of how the Fed’s tightening would ripple through the world economy. From the housing markets in Canada and Hong Kong to capital flows into and out of China and Turkey, the question isn’t whether there will be spillovers -- it’s how big they will be, and where they will hit the hardest.

Watching for the "sequencing" of events
If China were to devalue, it desperately needs to insulate both Hong Kong and their domestic companies from the worst effects of the coming storm. One of the key telltale signs of impending RMB devaluation would be the announcement of closer ties, cooperation,  or coordination between the PBoC and the HKMA. Another telltale sign might be steps that Beijing takes to insulate Mainland companies from their USD 1.1 trillion debt, such as the establishment of dollar swap lines with the Federal Reserve.

As an example, one step that Beijing seem to be taking as part of their financial liberalization is to use the power of the central government's balance sheet to alleviate the financial pressure faced by local authorities. They recently announced an initiative to replace part of local government debt with central government debt (via China Daily):
More than half of the high-interest local government debt that falls due this year will be covered under a debt swap plan arranged by the Ministry of Finance, which said on Friday that the swap would not raise the debt level further.

The ministry on Monday disclosed that it had ordered issues of 1 trillion yuan ($160 billion) of low-yield municipal notes that will replace legacy liabilities, in a bid to ease local governments' mounting interest repayment pressure.

An audit in June 2013 found local governments faced repayments of 1.858 trillion yuan in 2015. The debt swap covers 53.8 percent of that amount, and the conversion could reduce interest payments by 40 billion yuan to 50 billion yuan a year, according to the ministry.
Arguably, the formation of the Asian Infrastructure Investment Bank (AIIB) lays the groundwork for mitigating potential damage from a Chinese devaluation. The participation of major US allies such as the UK, France, Germany and Italy, in the AIIB are positive steps in the globalization of this initiative. In addition, countries like Australia, Switzerland and South Korea have expressed interest. However, the AIIB must be regarded as a long-term project and it would not be in a position to mitigate damage should the PBoC take steps to devalue in the immediate future.

In summary, just as the military intelligence analyst looks for signs that another country has WMDs, or is preparing to use them, the investment analyst can look for similar signs of central bank or finance ministry policy.

For now, I see little evidence of the sequencing of steps which indicate that the PBoC is getting ready to devalue the RMB in a massive way. While I recognize that pressure is building, the doomsters can rest easy - at least for now.

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