Why Markets Stopped Worrying About China's Dwindling Foreign Cash Pile

The flood of yuan out of the country inspires little more than a yawn.
Photographer: SeongJoon Cho/Bloomberg

At the dawn of 2016, the dwindling of China's massive hoard of foreign reserves sparked turmoil on global financial markets. Now, signs of accelerating capital outflows inspire little more than a yawn.

Figures published Wednesday showed the value of the People's Bank of China's foreign exchange reserves fell by $69.1 billion to $3.05 trillion in November, the largest drop since January. S&P 500 futures, however, showed no immediate reaction and benchmark U.S. indexes then rallied to all-time highs, a stark contrast to 10 months prior, when a similar drawdown was cited as the proximate cause of carnage in global equities.

One difference now is that China's capital account hadn't been as leaky ahead of November's large decline; market participants had seen far rainier days from mid 2015 until early this year. Outflows averaged about $60 billion from February through October, roughly half of the amount from in the prior six months, observed George Pearkes, Bespoke Investment Group's macro strategist.

CNGFOREX Index (China Monthly Fo 2016-12-07 15-27-06
Source: Bloomberg

"12 month forward prices have included lots of risk premium to make up for spot declines, softening the blow for the market," he writes. "Implied volatility also trades at a huge premium to realized volatility for CNH, and when vol ramps up, option sellers are already compensated against more violent price action." 

In other words, as traders have priced in a more volatile and weaker yuan relative to the U.S. dollar via the forward and derivatives markets, this also raises the bar for roiling the market through any surprise uptick in outflows.

USDCNYV6M Curncy (USD-CNY OPT VO 2016-12-07 13-48-29
Source: Bloomberg

Not everyone's convinced the sanguine reactions are warranted. 

"While an orderly pace of foreign exchange depreciation and an orderly pace of reserve reduction give the impression of calm, they bring to mind the image of a duck floating serenely over the water while it paddles its feet furiously below the surface," said Kit Juckes, global strategist at Societe Generale.

"Reserves matter if they point to unsustainably large capital outflows — that is, if the amount of paddling below the water to give the impression all is fine for the duck on top is so huge that the duck may have a heart attack, then we’ll start to really care again."

That's probably not the case just yet, he added, citing the slow grind higher for the U.S. dollar relative to the yuan and the stability of trade-weighted Chinese exchange rate in recent months, both in real and nominal terms.

RTWICNY Index (Westpac Real Effe 2016-12-07 12-46-10
Source: Bloomberg

Another reason for the relatively calm reaction: a mirror image of the reserve drawdown is a reduction in the net offshore liabilities of Chinese banks and non-financial corporations, said Karthik Sankaran, global strategist at Eurasia Group Ltd. In other words, China Inc. has been reducing asset-liability mismatches that it built up over the years, effectively reducing risks to financial stability. China's outstanding net cross-border liabilities have fallen to $140 billion in the second quarter of this year from $650 billion in the first quarter of 2014, according to Bank for International Settlements data.

"If you think about the ways in which a lower currency can hurt a country, it's an asset-liability mismatch, a small tradable sector that's unable to benefit, or such high inflation that nominal foreign exchange depreciation doesn't translate into real depreciation," he said. "None of these seem to apply in the Chinese case."

Meanwhile, David Woo, global head of rates and currencies research at Bank of America Merrill Lynch, said that the biggest difference between this year and the last is that China has shown its willingness to use tools to control any fallout.

Ahead of the inclusion of its currency in the special drawing rights basket of the International Monetary Fund in 2015, China "had to be seen as loosening capital controls," the strategist said.

Policymakers now are more willing to use levers at their disposal to an attempt to crack down on capital outflows, such as making it more difficult for residents to buy insurance policies in Hong Kong. There's some proof they've been successful in this regard: the sale of actress Cate Blanchett's Sydney home fell through when the Chinese buyer was unable to get enough money out of the country to settle the deal.

Woo said his real estate agent told him that "it's more difficult to go to the moon than get money out of China."

As such, capital outflows are now viewed by the market as a "controllable problem," he said.

But the issue with this, according to Oxford University China Centre Associate George Magnus, is that November's outflows are proof the capital account remains leaky.

While the resilience of headline economic data suggests that a "hard landing" for China is by no means imminent, recent gains also have come as policymakers backslide on fiscal stimulus reforms by returning to what's been called credit-fueled malinvestment. The more Beijing uses this vehicle to juice growth, the more capital will vote with its feet by leaving the nation, Magnus reckons.

"For the moment, non-FDI and regular outflows command less public attention than they did late last year and early this, when a) they were bigger than November and b) they were occurring in the context of what appeared to be a lack of control in markets and lack of authority in policymaking," he said. "One could argue that today both have returned."

For Martin Enlund, chief currency strategist at Nordea Markets, the question to be answered is not why investors aren't as worried about the drop in reserves, but rather why they've shrugged off the surge in the greenback.

After all, valuation effects — the rise of the U.S. currency lowers the value of non-dollar foreign reserves held by the People's Bank of China — accounted for almost half of the November decline in reserves, according to an estimate from analysts at Barclays Plc.

"Let me suggest that i) despite Fed repricing, U.S. real rates & financial conditions remain low, ii) macro hedge funds have been too negative on risky assets (meaning higher equities is the path of most pain), iii) drop in FX reserves roughly in line with expectations, iv) drop in FX reserves likely to be more muted in December unless USD repeats its November path (unlikely),'' said Enlund.

But investors who aren't worried about reserve sales and capital outflows in China may soon have their resolves tested. In January, citizens will get new quotes for exchanging their local currency into foreign dollars, potentially eliciting a repeat of the market turmoil that characterized the start of 2016.

"And why wouldn’t they convert like there is no tomorrow?" writes Scotiabank Vice President of Economics Derek Holt. "After another year of yuan depreciation, would you keep your life savings in a currency that is losing international purchasing power and within a banking and shadow finance system that gets all manner of negative headlines?"

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