The point of no return for China

An interesting piece of news in Xinhua:

BEIJING, Jan.6 (Xinhua) -- China faces a threat of "abnormal" cross-border capital flow because of global financial tumult, the country's foreign exchange regulator said Tuesday. Such capital movement, resulting from the world economic slowdown and financial crisis, will bring with it potential risks, said Hu Xiaolian, head of the State Administration of Foreign Exchange (SAFE).

China has cut interest rates and seen its economy slowing down since the global financial crisis hit the country's exporters. That could reduce its attraction to foreign investors and lead to capital outflows. More money flowing out of the border could increase the risk of liquidity strain in the country, which is especially dangerous amid the global financial crisis. "Where the money will flow to is quite uncertain," Hu was quoted as saying in a statement on the SAFE website.

China's foreign exchange reserves had fallen for the first time since December 2003, Cai Qiusheng, a SAFE official, told a conference last month. He didn't give specific data of when that happened or by how much.
[...]
The People's Bank of China said it will check the validity of trade payments and step up supervision on individuals carrying foreign currencies in and out of the country

This may be the first clear confirmation that China is experiencing capital outflows. According to Brad Setser at CFR, the decrease in the Chinese foreign reserves cannot be explained only by the fall of the euro component of the reserves:

Bottom line: I don’t think anyone outside SAFE has a good read on what is really happening. Today’s leaks probably refer to end November numbers. The end December numbers should be back above $1.9 trillion absent enormous capital outflows. Currency moves will push up the dollar value of China’s reserves in December, after pushing them down in October and November. Roughly $20 billion in valuation losses from currency moves isn’t enough to offset China’s likely q4 trade surplus ($75 billion in the first two months, likely to be close to $100 billion for the quarter). Even if $25 billion in equity losses are added to the $20 billion in estimated currency losses, China’s reserves should still be growing absent significant capital outflows …

But why the Chinese government would act so tough in imposing capital controls and try to prevent capital leaving the country, when they have $1.9 trillion in reserves?

The answer is quite obvious if we look at how a mercantilist currency manipulation scheme works. The subsidies for the export sector and are in fact paid from the new direct foreign investment flows into the country. The manipulated currency (yuan) is artificially kept with respect to the victim currency (dollar in our case) through sterilization (in order to avoid a domestic inflation explosion).

The sterilization works like this: China obtains yuan by issuing bonds on the domestic market, and those yuans are exchanged for dollars that are parked in US treasuries and agencies. It is basically a bond swap or an anti- carry trade currency operation because the rate results in losses (domestic yuan rates being higher than the dollar rates offered by US treasuries) . Satyajit Das from RGE has even a number for these losses:

China incurs costs – effectively a subsidy to its exporters - of around $60 billion per annum (the difference between the rate it pays on its Renminbi debt and the investment income on it reserves).

Assuming the number is correct and playing with some basic math, we can arrive at some interesting conclusions. Let's say, the average yield differential between the domestic debt and the US paper "investment" is about 3%. That would result in a cumulative size of the current debt swap operation of about $1.98 trillion dollars. If the average yield differential is 2% then the cumulative size of the debt swap is about $3 trillion.

I have no idea how old is the data regarding the $60 bil/y cost of the currency operation, but the cost is not only related to the yield differential but also to the yuan exchange rate. An evaluation of the yuan can prove disastrous.

The only way to keep the scheme going. is to cover the losses through direct foreign investment in China, and probably the balance is extremely tight, and that would explain why the Chinese government is so jumpy when a foreign investor wants to withdraw its money from China (as recently Bank of America found out).

It seems that the Chinese government is notw at the stage of grasping straws and, in the absence of foreign direct inflows, tries to find other ways to maintain the currency scheme going (another day or two).

On the domestic side it plans to prevent the collapse of the Chinese real estate bubble... by pumping more money into the bubble:
http://news.xinhuanet.com/english/2009-01/06/content_10613387.htm

BEIJING, Jan. 6 (Xinhua) -- China is considering introducing real estate investment trusts (REITs) to help increase financing channels for real estate developers, Qi Ji, vice minister of the Ministry of Housing and Urban-Rural Development told a press conference Tuesday.

According to Huo, outstanding loans of property companies totaled 5.24 trillion yuan (766.1 billion U.S. dollars) by the end of November, up 10.3 percent year on year. But the growth rate was 1.9 percentage points lower than October and 20.6 percentage points lower compared with the same period in 2007.

Probably somebody in China has high hopes to sell yuan denominated CDO's abroad.

On the external side there are efforts for avoiding the use of the dollar in the regional trade in order to reduce the size of the currency exchange operation (and consequently reduce the losses):
http://www.shanghaidaily.com/sp/article/2009/200901/20090107/article_387229.htm

CHINA'S central bank said yesterday that it plans to implement a pilot program that would settle overseas trade with the Chinese currency instead of the US dollar.

China will allow the yuan to be used for settlement between Guangdong Province and the Yangtze River Delta, China's two economic powerhouses, and the special administrative regions of Hong Kong and Macau, according to the central bank.

Meanwhile, exporters in the Guangxi Zhuang Autonomous Region and Yunnan Province in southwestern China will be allowed to use the yuan to settle trade payments with members of the Association of Southeast Asian Nations.

Those moves are expected to facilitate overseas trade, as Chinese exporters might face losses if they continue to be paid in US dollars, analysts said.

The excuse of trying to protect Chinese exporters would be credible if the yuan had continued to increase with respect to the US dollar. But that is not the case

Therefore the only available option to prevent an imminent collapse is to introduce capital controls, while devaluing the yuan further. But that will not work for long either ...