2012-08-24

More on shifting capital flows

The great benefit of Elliot Wave Theory and socionomics is in spotting the trend changes. If you know the larger trend, it's much easier to invest, especially for long-term, buy-and-hold investors. However, what's also important is the wide shift that takes place. It's not one trend that changes, everything could potentially change direction and also change in amplitude. With regards to China's massive forex holdings, the change will not be from steady inflows to relative balance, and the the change in the renminbi will not be from steady appreciation to fair valuation. Instead, the shift is likely to be from steady inflows to volatile outflows, from steady appreciation to rapid depreciation, because negative mood (bear markets) is more volatile.

This article is from May 2011. See how fast things have changed.
Settling in Yuan, Unsettling Forex Reserves
China added US$ 197.3 billion to its foreign exchange reserves in the first quarter – the second-biggest quarterly boost ever for the cash pile, which had grown at a record pace between October and December 31.

At the same time, the nation's international balance of trade slipped into negative territory as China posted a quarterly US$ 1.02 billion trade deficit, according to the government's customs agency.

A key factor behind what appeared to be clashing currency statistics was China's push for the yuan's use in cross-border trade settlements, a source familiar with the government's foreign exchange reserve agencies told Caixin.
Moreover, the expert said, net outflow of yuan could be expected at this early stage of the yuan trade settlement system. But in the long run, he said, those yuan will probably return to China through trade settlements or via direct foreign investments.

When that happens, yuan will begin replacing some of the dollars coming into the country and thus reduce the foreign exchange reserve's growth.

The tipping point, however, remains in the future. And no one has set a date for a new monetary climate marked by yuan inflow.

What's Next?

For now, the ever-rising nature of the foreign exchange reserves is stirring concern. Some in the government are looking for ways to invest the reserves and make more money. Others have raised red flags over soaring liquidity in China stemming from central bank's purchases of foreign exchange from exporters and banks, which puts pressure on monetary policy constraints and encourages hedging.
Usually, when something becomes a big problem that everyone notices, it's about to reverse. Everyone was getting worried about rapidly rising foreign exchange reserves, and less than one year later, the tipping point arrived. However, it wasn't marked by yuan inflow from abroad, it was marked by U.S. dollar outflow as investors and Chinese citizens take their assets out of China.
Indeed, Citibank's China analyst Peng Cheng thinks appreciation of the yuan is at the root of the foreign exchange growth problem. And since the currency is expected to continue appreciating against the dollar, he said, the reserves will likely grow.
In November of last year, the yuan stopped appreciating. Problem solved!

Now here's an article from the past week.
Revamping the Landscape of Forex Flows
In the first six months of the year, China's capital account saw a deficit of US$ 20.3 billion, and its accumulated forex reserves grew to US$ 3.24 trillion, up only US$ 63.6 billion -- 77 percent less than the amount added in the first half 2011, data from the State Administration of Foreign Exchange (SAFE) shows.

But this does not indicate capital flight, the regulator said. Instead, it primarily reflects shifting foreign exchange activity from the central bank to domestic institutions and individuals, it says.
It represents capital flight from the renminbi and the central bank, what those individuals do with the money is another story.
However, with the inflow of foreign capital slowing and the funds outstanding for foreign exchange declining as a result, concerns are rising that there might be a liquidity shortage in the domestic market.
When a Chinese exporter sells $1 to the central bank, the central bank issues ¥6 in new currency. When a Chinese investor or currency speculator buys $1 from the central bank, the PBOC buys back the ¥6 and takes it out of circulation.
Reducing banks' reserve-requirement ratio (RRR) is another effective method to bump up liquidity, Wang said. Based on his calculation, lowering the RRR to the level of a decade ago, 6 percent, could offset the impact of 1.9 trillion yuan flowing out of China. Yet "it's almost impossible for such a massive capital flight to occur, unless there is an economic or political crisis that completely shatters the confidence of the middle class," he added.
It can't offset the impact because without the foreign currency backing the renminbi, the value will plunge. The liquidity crunch is deflation and the "solution" is inflation.

Confidence doesn't need to plunge to have a crisis, it only requires the herd to change direction, something that happens in cycles throughout history. That said, there are some things that add to the shifting trend, confidence destroying problems that could speed up the process.

A Vital Problem (心腹之患)
However, none of these compares to the threat of vested interests that are infecting the vitals of China's economic development.

This is a true story I've heard recently: in the province of A, an entrepreneur whom I shall name B, had accumulated some capital after twenty years. He invested in a local financial company, whose majority shareholder is the government.

Since becoming a shareholder of a government-backed firm, bank financing had become much easier for B. Though one may doubt if the loans were obtained under complete compliance with regulations, the premium and interest payments had been regular.

Then a company with a deeper background, which I shall call C, became interested in this financial company, and became the second-largest shareholder through capital increase. The process, at least on the table, was open, just and fair. C gained de facto control over the management of the financial company.

And that was when B's trouble began. As C started to clear out loans to shareholders, B initially tried to resist. Only when C leveraged government power, did B relent and agree to repay everything. But C wanted more.

As it turned out, the initial objective of C was to also buy out B's shares at a discount price. The end of this part of the story is not yet clear.

B appeared rather weary-looking the last time I saw him. During our private conversation, he mentioned the idea of selling off his assets, close shop and move far away.
How many private investors and business owners in China are waiting for the day when someone with more powerful government connections will make them an offer they can't refuse? In preparing for that day, one strategy is to take as many assets as possible out of the business and move them overseas, far out of the reach of corrupt hands.

Mood in China is definitely negative, but the Shanghai Composite has not breached its 2008 lows. Whether it moves up or down, I expect it will continue to fall in terms of gold—the Shanghai Composite/gold ratio hit a new low on Friday.

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