Monday, March 03, 2014

Has the Falling Yuan and Tumbling Chinese Stocks Been Signs of Capital Flight?

I have raised the issue that the disorderly yield spread adjustments have landed on the shores China’s financial markets.

At the start of the year or prior to the Chinese New Year, a liquidity squeeze, as expressed by high interest rates, on the shadow banking industry has prompted the Chinese government to bailout one of the afflicted trust company[1].

Over the following month, the government via the central bank the PBoC appears to have worked on to stabilize the strained credit markets.

Lately a new form of strain seem to have afflicted the Chinese markets; the Chinese currency has stumbled to a record low

From Bloomberg[2]:
China’s yuan tumbled by the most on record on speculation the central bank will widen the currency’s trading band, allowing greater volatility at a time when growth is slowing in the world’s second-largest economy.

The yuan slid as much as 0.9 percent to a 10-month low of 6.1815 per dollar, the largest decline since China unified official and market exchange rates in 1994, according to data compiled by Bloomberg. The currency lost 1.3 percent in February, the biggest monthly drop on record. Trading in yuan options surged in New York, making them the most traded contracts among major currencies.


The above is the 3 year chart of the USD-yuan which shows this week’s record dramatic fall yuan or surge in the USD.

There has been many rationalizations from the above ranging from plans to double trading bandwith in order to liberalize exchange rate, to acts by the PBoC to attack currency speculators and a supposed recourse to devalue in order to promote exports.

I am not persuaded by all these. Speculation that the Chinese government wants to liberalize contradicts her very action of conducting a bailout, extending subsidies to automarkers[3] and of the recent interventions by the PBoC to stabilize the market via injections or withdrawals of liquidity.

Next if the current problem of the Chinese government has been the greater risk of an economic slowdown due to debt woes, how will devaluation ease on her debt conditions? If Chinese exporters who rely on either banking system or shadow banks feel tighter credit conditions via limited access to affordable credit impede on their operations, how will the problem of access to cheaper credit be resolved by a cheaper currency?

Third, why would the Chinese government want to attack the so-called entrenched one way street speculators? Is the Chinese government ready to prick on the interest rate carry trade where nationality based dollar bonds and bank loan exposures by Chinese companies have totalled $ 655 billion at the 3rd quarter of 2013 according to estimates by Bank of America Merrill Lynch? And what’s the point of the earlier bailout?

Moreover is the Chinese government willing to pop about $350 billion worth of complex derivative called the “target redemption forward” (TRF) mostly sold from last year and which according to Morgan Stanley analysts, there remains about $150bn outstanding? The TRF has reportedly been a popular bet on the firming yuan. And since the TRF seems a levered bet, the Financial Times reports that should the renminbi break past 6.20 per dollar, analysts warns that there will be a huge collateral call where “hedging strategies could force banks to call in collateral, accelerating the currency’s decline.[4]

So it would be bizarre for the Chinese government roil the markets in the face of growing debt concerns.

The Chinese government seems to have managed calm many segments of the credit markets.

But credit strains remain as banks have reportedly been reluctant to lend to each other.

From another Bloomberg report[5]
China’s credit-market gauges are triggering alarm bells, as banks grow cautious in lending to each other while investors prefer the safest government bonds.

The spread between the two-year sovereign yield and the similar-maturity interest-rate swap, a gauge of financial stress, reached 121 basis points on Feb. 19, the widest in Bloomberg data going back to 2007. Two days later, the cost to lock in the three-month Shanghai interbank offered rate for one year reached an eight-month high of 94 basis points over similar contracts based on repurchase agreements, which are considered safer because they involve government securities as collateral.

Billionaire investors George Soros and Bill Gross have drawn parallels between the situation in China now and that in the U.S. before the 2008 financial crisis, when traders gauged lending appetite by monitoring the difference between the London Interbank Borrowing Rate and the overnight indexed swap.
So the debt problems appear to be leaking out from various segments of the marketplace. 

Absent in the radar screens of the consensus has been the dramatic fall of China’s stock markets which appears to be one market that has reacted violently to the yuan’s weakening.


The Shanghai index fell by about 5% in four days[6], before recovering part of the early losses. By the week’s close, the index lost 2.72%. This week’s loss essentially wipes out over 1 month of gain. This is fundamental example of volatility in both directions with a downside bias. 

Why should the stock market react violently if a falling yuan merely has been about liberalization, or devaluation or attack on currency speculators?

I would add that new reports peg debt by Chinese non financial corporations at about $12 trililon or equal to over 120% of GDP based on Standard& Poor’s estimates[7]. The fast expanding size of China’s debt levels is by itself creating risk dynamic.

I offer you my guess. This is not one which the PBoC may be in control of for now. The PBoC seem to be focusing on credit markets. What they or the consensus seem to be missing or ignoring is that these could be incipient signs of capital flight. This may even be capital flight by those in power. The PBoC could be trying to deflect on the issue by putting up strawmen.

And if I am right about this, and if the yuan falls more, we could see the next financial tremor soon.

Given that some publicly listed domestic companies has business exposure on China it would be logical for them to have access to credit. Perhaps I would have to take a look at their exposures.

[4] Financial Times Falling renminbi heightens derivatives risks February 27, 2014

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