Bloomberg Stares Into the Abyss

Q: If China Sees Capital Outflows Now, What Happens in Crisis?

A: Fire and brimstone coming down from the skies! Rivers and seas boiling! Forty years of darkness! Earthquakes, volcanoes... The dead rising from the grave! Human sacrifice, dogs and cats living together... mass hysteria!

“We have both a booming stock market and capital outflows, which is counterintuitive,” said Jean-Charles Sambor, Asia-Pacific Director at the Institute of International Finance in Singapore. “The downside risk would be to have broad-based outflows if the macro story deteriorates further or the stock exchange collapses, which would create a confidence crisis.”

...So far at least, officials are playing down the risk. Guan Tao, head of the State Administration of Foreign Exchange’s international payment department, on Thursday said the outflows weren’t surprising and that authorities aren’t considering new measures to clamp down on departing money.
"When it becomes serious, you have to lie." I don't think the authorities are lying now.
...One trigger to accelerate the outflow could be a steep correction in stock prices that spurs domestic investors to seek safety in overseas assets. The Shanghai Composite Index has soared about 90 percent over the past six months as the central bank cut interest rates and took steps to revive lending growth.
Why would this be? Equities are rising as outflows rise. One possibility is that stock prices and capital outflows are not related. Another is that stock prices and capital outflows are inversely correlated. Another is that both capital outflows and stock prices are both affected by the same variable.

Perhaps fear of currency depreciation?

Up China’s sleeve is plentiful ammunition to fight speculators if it ever came to a crisis. The People’s Bank of China can lower the amount of reserves banks must hold, pumping cash into the system to offset outflows. Then there’s the $3.73 trillion pot of foreign currency reserves it can use to shore up the yuan, as analysts say it did in the first quarter.

“If there is an economic crisis, my guess is that the fear-driven outflows could rise sharply, putting immense pressures on the PBOC’s foreign reserves,” said Stephen Jen, co-founder of SLJ Macro Partners LLP in London and a former IMF economist. “But the foreign reserves are there for a reason, precisely to meet this contingency.”
Nope. Foreign reserves are there because when dollars come into China, the central bank swaps renminbi for U.S. dollars. Rising reserves caused by dollar inflows are inflationary in the financial system. If China uses reserves to buy up yuan, it is contracting the money supply. Deflation. The very thing that may force a crisis in China is disinflation or deflation in the financial system. A falling yuan is the market's response to seeing a deflationary threat in a currency that is backed by a foreign reserve currency.

The only thing China can do for certain is arrest a decline by revaluing the renminbi or announcing their gold holdings. Markets always overreact, so instead of USD/CNY going to 8:1 in a crisis, the Chinese government might be able to halt a decline at 7:1, but only if that's in the ballpark of the real value. If China tries to halt the decline at 7:1 and the market wants to take it to 10:1, then China will be no more successful than Thailand in 1997 or Mexico in 1994. China was very successful in 1994 when they devalued big. Do you think they learned from their success?

If the currency needs to fall and doesn't (if it is really overvalued), exports will collapse and capital flows will intensify as Chinese flee an overvalued yuan via other means because putting up capital controls would not stop Chinese citizens from dumping RMB for gold, stocks or houses. The CCP or PBOC can decide what sectors pay the price or reap the rewards, but they cannot make the Sun rise in the West or even control real long-term interest rates. Every action has a cost: TANSTAAFL. If China decides it doesn't want the price to paid with the currency, then it will have to pay another way.

Chinese leaders, ironically, have the most control over their economy and yet appear to be the most pragmatic of all. Over in the U.S. and Europe, there is a whiff of panic if stocks drop a few percentage points. The economy more and more becomes the simulacra. Instead of minding the real economy, leaders are focused solely on the copy of the copy, a market where paper representing shares of companies is the most important thing in the world and if it drops a few percentage points, central planners panic and try to prop it up, as if the numbers going up on the S&P 500 Index will somehow flow backwards through the system and cause reality to change. Aside from the weak wealth effect, it is no more successful than coloring on a map and expecting the dirt beneath your feet to change color.

There's nothing new about China other than it is the largest Asian nation to embark on the development path. Maybe undemocratic state run market socialism will prove to be more successful than democratic state run market socialism, but other than a few tweaks, China will not escape history and the laws of economics. The real threat to the markets is the gap between perception and reality, from people who are making bets based on the idea that "this time is different." In the case of China, they're no more wrong than they are elsewhere. Most likely, if China has a major crisis, it will unfold amid a global crisis. Hopefully, the adjustment is not extreme and there isn't a recession that will Be "Remembered For 100 Years".

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