We also think global markets may be under appreciating the problem.
As far as we see it, markets have become far too used to a one-way discourse when it comes to China. They presume capital only goes in one direction. Into China.
This is understandable given that Chinese authorities (for years) have been intervening in foreign exchange markets to stop inflows from influencing the yuan’s value, a move designed to keep the yuan structurally undervalued and China competitive in global trade.
It’s actually a very similar situation to what the Swiss are doing now. By enforcing a 1.20 CHF/Eur floor the SNB is keeping the Swiss franc structurally undervalued much in the same way. Everyone knows that without the SNB’s intervention the franc would trade much stronger.
But stopping capital outflows from influencing the exchange rate is much harder. For one thing, it takes plentiful foreign exchange reserves.
Indeed, if capital outflows are large enough, the “peg” (or floor) not only becomes extremely expensive to manage, it eats ever more severely into your foreign exchange reserves.
Once your reserves run out, meanwhile, the game is largely over. Just ask George Soros about how the mispricing of the pound in the ERM led to the infamous “breaking” of the Bank of England.
Of course, when it comes to China, the going opinion is that China’s reserves are so large, there is no risk at all that the People’s Bank of China can be broken in the same way.
But that’s forgetting that when it comes to its foreign exchange reserves China sits between a rock and a hard place. Its Treasury position is so large, any liquidation could risk the country becoming the US Treasury market (and just ask JP Morgan about that…) killing value for China as well as for the world’s US bond investors.
Accordingly, it’s much easier for China to simply abandon the peg if the outflow problem persists.
This is especially the case if it can dress up the whole affair as an “empowering” move, attracting international headlines like this and this. Furthermore, if by “opening up the RMB” it can encourage more investment or settlement in RMB — a move which would be naturally supportive for the renminbi — without having to compromise on competitiveness.
Nevertheless, until the RMB becomes fully internationalised, capital outflows do remain a risk for China’s national cash pile.
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).
Which means it’s worth knowing just how wealthy China’s wealthiest 1 per cent really are?
As Shih observes, if wealth is fairly distributed across the nation, it would be much more difficult to deplete the equivalent of the national reserves. On the flip side if these households’ wealth totals well above China’s $2.8tn foreign exchange reserve, it would only take the partial reallocation of their wealth overseas to cause a substantial depletion of its cash pile.
Even when there is capital control and the state’s propaganda machinery instills confidence in the vast majority of the population, panic even among a subset of this richest—and also the most knowledgeable– set of insiders may have an enormous impact on the foreign exchange reserve.
Got any anecdotal reports of wealthy Chinese billionaires banging on your door to give you money?
As an aside, we hear there are some interesting developments in Macau already.
How to marry a Chinese billionaire – CNBC
China’s investors redraw the map of the art market – Guardian
Yuan depreciation a realistic possibility – Reuters