Thursday, May 31, 2012

What's the risk of capital flight in China?

I wrote before that the likely negative surprise was going to come from China and not Europe (see Focus on China, not Europe). Yes, I am worried about China, but my concerns are longer term oriented.

No, I am not as concerned about the possibility of a slowdown in China, as per Marc Faber on CNBC:
“As an observer of markets – whenever everyone focuses on one thing – like Greece and Europe – maybe they miss issues that are far more important – such as a meaningful slowdown in India and China.”
No, I am not as concerned about the disappointment over the size of the announced stimulus program. The market rallied initially when the news of the stimulus program hit the tape and official media announced that it was RMB 1 trillion [emphasis added]:
In the context of complicated and changed economic situations, the Chinese government has vowed to make some tailored changes to its established macroeconomic policy. At an earlier State Council meeting, a consensus was reached that China will accelerate the approval of some infrastructure projects, promote consumption of energy-saving home appliances and increase tax cuts on enterprises in a bid to ensure steady growth. China's central bank also announced a 50-basis-point cut for banks' reserve requirements on May 12, the second such cut this year and a third since December, which will release more liquidity. The stimulus packages are expected to reach 1 trillion yuan ($158 billion).
The markets then sold off the next day when it realized that the size of the program is only one-quarter of the size of the 2008 RMB 4 trillion program. What did you expect? They announced that it would by RMB 1 trillion!

Is China's business elite losing confidence in China?
Here's what I am worried about: There are signs that the Chinese business elite is losing confidence in China, which could result in a disastrous run on the RMB.

To set the stage, FT Alphaville highlighted a paper by Victor Shih of Northwestern University that illustrates the vulnerability of China's vaunted foreign exchange reserves:
And on that note, we found some of the points raised in this 2011 paper by Victor Shih from Northwestern University extremely insightful.

For one thing, did you know that China’s wealthiest 1 per cent could determine everything?

Consider the following points (emphasis ours):

China in fact faces three major structural causes of capital flight.

First, the empirical portion of this paper will conduct three calculations to show that the wealthiest 1% households in China commands wealth that is at least as large as 2/3 of the foreign exchange reserve and possibly as high as nearly twice its size.

Thus, if the top 2.1 million households in a nation of 1.3 billion people decide to move even 30% of their wealth overseas, the foreign exchange reserve will reduce by a trillion dollars or more.

Second, despite official foreign exchange control, numerous channels, especially those through China’s current account, exist to move capital in and out of China.

Third, households, which are net savers, face a negative 3 plus percent in real return from bank deposits and Chinese treasury bonds, forcing them to constantly look for higher returns than inflation rates.

These three conditions combine to create extremely fragile conditions for China’s foreign exchange reserve, which is the backbone of the entire financial system of China.

If the foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector (Walter and Howie 2011; Shih 2004).
In other words, the Shih paper says that China's foreign exchange are highly vulnerable to a loss of confidence by its business elite.

So what? That's just like saying that a banking system, any banking system, is vulnerable to a loss of confidence. What if all the depositors all rushed to get their money out of the banks at the same time? If you had been predicting doom in the banking system in the last 50 years based on this premise, you would still be waiting for the collapse to occur.

What you need is a catalyst, a loss of confidence, for a catastrophe to occur. There are signs that a loss of confidence by China's business elite seems to be happening. I wrote on Monday that:
FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China in 20 years
Capital flight?
OK - so they are starting to lose confidence in China's long-term growth outlook. What are they doing about it?
Look at this chart from Bianco Research of China's net purchase of Treasuries. They went NEGATIVE a few months ago and ticked back to positive, but net purchases are still net negative on a rolling 12 month basis.
When I added two and two together, this story of a USD shortage in China now makes sense:
We noted last week that there was a rising tussle over dollars in China, spurred by capital outflows and RMB-denominated selling on signs that the world’s key economic powerhouse may be slowing. A situation which was arguably thrusting China into a dollar short position.

While that might seem counterintuitive given China’s substantial longer-duration dollar assets, it is possible because of China’s substantial short-term dollar liabilities. Essentially, we’re talking about a dollar-denominated duration mismatch on the mainland at a time when China is running one of its largest outstanding external debt positions for 27 years.
When I worked with our emerging market investment team, the team head told me that one of the buy signals for a country is when the locals start to repatriate funds from abroad (and he was referring to Latin America at the time). What we have in China are signs of a loss of confidence, followed by indications of capital flight - all very bad news.

To be sure, I may have just misinterpreted the data and wrongly concluded that capital flight is occurring. Another explanation is that this episode of capital flight is just a momentary flash of panic, created by the uncertainty that accompanies a change in leadership.

Let me make myself clear: A collapse in China's foreign exchange account is not my base case scenario. Such a loss of confidence would not just mean a hard landing involving sub-par economic growth, but a crash landing involving negative GDP growth, which would totally freak out the markets. Nevertheless, the probability of such an event is small, but non-zero - and definitely not discounted by the markets at all. What worries me is that the markets start to get a whiff of this story and starts to price in this kind of tail risk. That's when the trouble begins.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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