Chinese Yuan On A 'Knife-Edge' as Private Capital Outflows Accelerate

Private capital is flowing out of China at record levels as domestic investors look to invest money overseas before authorities devalue the yuan further.

The People’s Bank of China (PboC) has been fighting a losing battle to contain private capital outflows by artifically trying to prop up the yuan, by selling its FX reserves. 

The action is aimed at stemming the negative effects of capital flight on the domestic economy and to support the government’s intention of turning the export orientated economy into a more consumer-led economy.

The PboC’s markedly lower yuan daily currency fixings last week, however, were a sign it was failing to prop up the yuan with reserve selling, perhaps as it was unable to match outflows – and or because of a change in policy direction.

Analysts at RBS see the PboC potentially giving up the battle and accepting devaluation as a tool to stem outflows in itself.

This would be to protect its rapidly decreasing reserves:

“The worst case for China was always going to be ‘do nothing, let capital outflow (bad for the domestic economy), offset by reserve selling, and when reserves run out, then devalue, but from a position of weakness’.”

If the trend in outflows continues it could have enormous implications for global FX, in particular the dollar which stands to be the primary beneficiary of escaping funds.

How the Pboc handles the crisis and whether it can stem the outpourings may have further implications on major currencies.

If it stops selling resrves and allows a rapid devaluation we could see a spike in the dollar, but then a plateauing of demand, as the currency becomes too expensive to draw continued interest from Chinese investors.

Potentially this could see Chinese flows divert to other more affordable currencies such as the euro, which has already seen a spike in interest from Chinese investors.

Jugular Haemorrhaging

Researchers at J.P Morgan estimate net capital outflows - that is outflows minus FX interventions from the Pboc - have hit record levels of $280bn in Q3 2015 and $210bn in Q4.

Much of the capital is going into the dollar, which would explain why the currency has appreciated so rapidly recently, particularly on negative China news.

According to research from J.P Morgan, a considerable chunk of the capital is going into covering dollar shorts as a high contingent of carry trades are unwound.

Chinese private investors and corporates had been heavily invested in ‘carry’ or interest rate arbitrage trades which involved selling the dollar and buying the yuan, and then profiting from the interest rate differential.

As the Pboc has eased rates in China and the Fed has increased interest rates in the U.S, however, the trade has looked increasingly less attractive, and according to J.P Morgan:

“Corporates have been at the epicenter of these flows as expectations about renminbi appreciation started reversing in 2014, inducing corporates to use trade credits, foreign currency loans and deposits to unwind carry exposures, i.e. to reduce previous interest rate arbitrage trades between the dollar and the renminbi.”

The Mystery of Flat U.S Treasury Yeilds 

A further beneficiary are safe-haven assets such as U.S Treasury Bonds, which would explain why yields have remained so low despite two events which would normally cause yields to spike higher: that is the Fed raising rates in December and last Friday’s massive 293k Non-Farm Payrolls result.

It may well be that Chinese money is part of a massive injection of capital going into U.S Treasury’s, and thus helping to explain why long-dated bonds of 10 plus years are seeing so much demand. 

Chinese Snapping Up European Assets

However, there are signs too that the euro-zone may also be benefiting from fleeing Chinese capital, as the Spanish property market, for one, has seen a spike in buying interest from China recently, which supports data indicating the arrival of green shoots of hope in the euro-zone property market, especially in Germany and Spain.

According to a source close to the property market in Spain, there is increased interest from China:

“A big Chinese conglomerate is buying into the Marina D'Or tourist complex in Castellon province and I know they are buying up commercial property in Madrid.”

Indeed, the renminbi is still relatively strong compared to the euro and therefore Euro-zone assets represent a good investment deal from the Chinese perspective.

The dollar is comparatively expensive already for Chinese investors after reaching a 5-year high versus the renminbi, and if the trend continues Chinese investors may see diminishing returns – although the fact analysts at RBS still see the renminbi as 20% overvalued, could also indicate the currency has still got much lower to go against the dollar, which is still expected to see gains from the capital outflows.

This may also explain why the euro has responded positively to negative Chinese news and data – it too, like the dollar has been a beneficiary of the capital rout.

This may also further explain why EUR/USD remains so flat, as both are gaining in roughly equal measure from Chinese investment.