There is a huge developing story in China’s currency, the renminbi.
After years of structural under-valuation, things are changing.
This might seem counterintutive given China’s large stock of US Treasuries, but we promise, this is a real and growing problem.
As it stands, China sits on a huge pile of Treasuries it can’t openly liquidate for fear of sending the wrong signal to the Treasury market, as well as fear of moving the underlying. But at the same time it is finding it ever harder to absorb dollars from the system, because fewer surplus greenbacks are making their way into China via trade.
Ordinarily, China offers traders the chance to exchange dollars — received through their business practices — for renminbi at the standing PBoC renminbi rate.
This bid is always attractive for traders because on a structural level it is undervalued versus the dollar. (Traders get more renminbi than they probably should.)
Since this creates an excess renminbi liquidity issue, the government simultaneously offers yuan-denominated bills to the market so as to absorb the huge amounts of yuan-denominated cash that it creates. But, whilst this creates big yuan-denominated liabilities for the government, the process also creates large dollar-denominated assets, which are usually reinvested into dollar-denominated “safe” securities like Treasuries (or GSE paper before 2008).
In the last few years, of course, it’s been more than dollars that the PBoC has been picking up from the market, and it’s been more thanTreasuries they’ve been reinvesting into. Nevertheless, the dollar and Treasury positions are still the most influential and the ones that are cause for the greatest concern.
Yet, with fewer dollars making their way into the system, and with some Chinese corporates even finding themselves short of dollars, the official PBoC yuan bid has not been enough to entice dollars into government coffers.
Without dollars to purchase, the yuan-liquidity tap is effectively turned off and the PBoC is forced to turn to alternative liquidity tools, such as the repo markets.
Instead of selling yuan-bills outright, the PBoC is forced to do the opposite, because there are now too many bills circulating through the market and not enough liquidity.
It’s one reason why Chinese repo rates have been so volatile of late (and also why they’ve been moving higher steadily since 2009, since the more bill supply there is out there, the higher the repo rate goes):
The PBoC has tried to manage this by conducting LTRO-style operations.. (though on a shorter duration). This sees them lend out liquidity against yuan bills on an ever more frequent basis. They call these “reverse repo” operations.
They’re seen as preferable to an RRR cut, because the latter has an inflationary stigma attached to it. A high RRR is also needed to sterilise reverse repo operations.
The problem the PBoC now has, however, is that its stock of yuan bills is growing quicker than its stock of US Treasuries. This has consequences for its ability to control the yuan-dollar peg.
If the situation worsens, and the dollar shortage gets more extreme, there will come a point where Chinese dollar liabilities will be stretched to the limit, and potentially defaulted upon.
There are only two solutions. Unleash the dollar reserves back into the system — a move that risks toppling markets across the board — or allow greater convertibility of the yuan, encouraging foreigners to exchange dollars directly for yuan.
Option 2 is naturally the far more logical.
No wonder we are hearing ever more talk about “convertibility” and “internationalisation” of the yuan out of Beijing.
But, dare we say it, this talk is also a major bluff.
After all, for the strategy to work China must maintain the impression that it’s still a good investment opportunity for foreign capital, and not an economy that’s on the brink of collapse.
The sad truth that many don’t realise is that these moves to internationalise the currency have less to do with Beijing’s wish to modernise and much more to do with a need to draw dollars into the system to cover the country’s growing “dollar short” position.
But what happens if the strategy fails? What happens if foreigners decide the last thing they want is yuan exposure (due to China economic bubble fears), and would much prefer to keep hold of their US dollars?
What happens if instead of a dollar inflow you get a mass capital outflow from China, with as many Chinese as possible converting yuan-denominated assets into dollars, seeing the yuan fall in value versus the dollar due to what is now an over-valued position?
Recent developments in offshore/onshore markets and forward markets, unfortunately, seem to suggest this is exactly what’s happening.
In other words, the bluff is not working.
As Michael Derks, chief strategist at FXPro noted on Wednesday:
Overnight the Chinese currency has continued to lose ground against the dollar, with yuan forwards declining to a four-month low. The explanation for the continuing softness in the renminbi is twofold – the dollar is in high demand at a time of enormous uncertainty over Europe’s future, and domestic economic conditions in China have been much weaker than expected.
Twelve month NDFs are trading at a 1% discount to the onshore spot rate, which implies that the forward market expects a depreciation of the yuan over the next year. As we noted in an extensive blog piece yesterday (More RMB depreciation cannot be ruled out), capital outflow from China has been accelerating in recent weeks, with the likes of the dollar and sterling the major beneficiaries. This capital outflow is likely to be in evidence for some time.
In which case, forget about Greece and the euro. China’s capital outflow problem is the real ticking time-bomb for markets.
If China fails to plug this problem sharpish, the world’s biggest put option — the China growth story — could quite genuinely come undone.
China equilibrium *alert* – FT Alphaville
Chinese CNH – YOURS! – FT Alphaville
When multilateral monetary policy is not an option… – FT Alphaville
The PBoC’s “unofficial” rate policy – FT Alphaville
RRR cuts ≠ credit easing. Keep saying it. – FT Alphaville
China Real Estate Unravels – Patrick Chovanec