2013-09-05

Andy Xie on Chindia Weakness, China Forex Risk

The free trade zone in Shanghai will accelerate the trends he mentioned, if the yuan is fully convertible within the zone.

A Tale of Two Giants
China's capital account is closed. This makes any currency attack difficult. But there are ways. Capital outflow through the gray market is probably hundreds of billions of dollars per annum in size. It is an open secret that Macau launders vast amount of Chinese money out of the country. It has the potential to expand the non-deliverable forwards (NDF) market for yuan offshore. In theory an NDF market is a betting market like a casino. The trading parties have no way to hedge their positions somewhere else. In reality this is not the case. Those who sell the yuan in the NDF market probably can move yuan from onshore to offshore and vice versa. Hence, they are arbitraging the price difference. In the last two years, the decline in China's forex reserves has correlated with the price difference between the official yuan exchange rate and the NDF market price. In a roundabout way, China is also using forex reserves to defend the currency. As the NDF market is still small relative to China's forex reserves, the danger is not immediate. Over time, the NDF market may become large enough to threaten forex reserves. An attack then is possible.

China's offshore-listed stocks are now the targets. In particular, bank stocks are quite vulnerable. As the land bubble bursts, large amounts of non-performing loans are inevitable. Unless the government takes quick action to recapitalize banks, their stock prices could collapse like U.S. banks did in 2008.

How quickly the United States unwinds QE influences potential financial attacks on China or India. If the Fed announces reduction of its QE by US$ 10 billion per month late in September, the attacks on India's currency and China's bank stocks will escalate. If it is US$ 5 billion, the more serious consequences could be delayed.

...Few countries have ever reformed to prevent a crisis. This time may not be different. The voice of defending the past seems quite loud. Inertia in policymaking comes from the fact that government leaders do not change without a major crisis. They are wedded to their past out of self-interest. Otherwise, how could they justify their continuing existence?

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