It's a tough time to be a Chinese policymaker.
Obvious overcapacity in industrial sectors forced the world's second-largest economy to shift to a more consumer-oriented growth model.
Maintaining an elevated currency was conducive to this goal, as it boosted the purchasing power of Chinese citizens.
But the yuan's peg to the U.S. dollar constituted an effective tightening of financial conditions as the greenback soared, despite a deterioration in the Chinese growth outlook. Even with continued current account surpluses, the currency appreciation was also beginning to hamper Chinese competitiveness in an environment in which external demand remains lackluster.
Meanwhile, the liberalization of China's capital account over the past five years provided a conduit for market forces to exert greater pressure on the exchange rate.
The manner by which the People's Bank of China has been able to maintain an overvalued yuan—by intervening in foreign exchange markets—effectively dried up domestic liquidity, which serves as a rising potential vulnerability for the economy in light of China's dependence on cheap credit for growth. When policymakers moved to devalue the yuan, market turmoil soon ensued—and China's fingerprints were all over some of the bizarre moves that occurred in equities and fixed income last week.
How Chinese policymakers elect to manage the currency in the face of continued capital outflows will likely play an outsize role in determining whether the current respite from market volatility will endure or prove to be the eye of the hurricane.
Here come the capital controls
Société Générale China economist Wei Yao thinks Chinese policymakers will take a measured approach to solving this conundrum—allowing the currency to depreciate in a controlled manner while placing more restrictions on the flow of capital out of the country.
Yao notes that in this discussion, it's important to distinguish which variable is the dog and which is the tail.
"The total size of capital outflows, among other factors, is mathematically a function of the PBoC’s choice of currency policy, not the other way around," she writes. "That is, total capital outflows equal the current account surplus plus the amount of FX reserves that the PBoC is willing to sell based its target for the RMB relative to the market’s view."
The largest source of capital outflows over the fourth quarter of 2014 and first quarter of 2015 has been declines in loan and trade financing liabilities by China's corporate sector, with the majority of those flows attributable to debt deleveraging.
The second-biggest source of capital outflows, "net errors and omissions"—essentially, what's left over after all the other sources of capital flows are classified—is more nefarious in nature.
"The fact that the second biggest outflow item is a statistical residual offers no relief," writes Yao. "We also find that this residual item has been sensitive to currency movements and expectations as well, hinting at something more sinister than just an innocent glitch."
The economist concludes that a portion of these flows constitute evasion of Chinese capital controls.
On one hand, the plunge in Macau gaming revenue would seem to imply that the authorities have been winning the battle to crack down on corruption and capital flight by Chinese elites. Other proxies, however, such as Vancouver real estate values, would suggest the opposite—as would the chart above.
So if the People's Bank of China is committed to continued depreciation of the currency, the two largest sources of capital outflows are likely to increase in magnitude, Yao concludes.
Fuel in the form of FX reserves
Though there are areas of vulnerability, the composition and size of external debt among Chinese corporates won't be enough to dissuade policymakers from seeking a weaker yuan, the economist believes.
But to bring the currency into a controlled dive while the Federal Reserve gets ready to raise its key policy rate will require the Chinese pilots to expend a significant amount of fuel in the form of foreign exchange reserves.
Yao sets a ceiling for reserves sold by the People's Bank of China at $1 trillion.
To reduce the extent to which the People's Bank of China needs to offset outflows with foreign exchange intervention, the economist sees a high probability that capital controls will soon be instituted.
"Liberalisation of resident flows has been much slower than other parts of capital accounts and will probably halt in the near term, given that Chinese flows are already the biggest sources of outflows," she writes.
This solution, the economist admits, is only a temporary one, as the People's Bank of China doesn't have an unlimited amount of foreign assets to sell to defend the currency.
And while a free-floating currency would cause too much short-term stress, this Band-Aid approach won't stop the bleeding.
"Not letting the currency go requires significant FX intervention that will not prevent ongoing capital outflows but which will result in tightening domestic liquidity conditions; but letting the currency go risks more immense capital outflow pressures in the immediate short term, external debt defaults and possibly further domestic investment deceleration," says Yao.