Last week while most people were fretting about the nightmare that would be a Larry Summers appointment to chair of the Federal Reserve, I was fretting about another nightmare of equal if not greater proportion.
On Friday, July 19 the People's Bank of China (PBOC
) eased credit conditions by removing the floor on bank-lending rates. This did not see much reaction from US markets, but I believe this move signals the severity of the credit contraction due to capital outflows. This easing of monetary conditions is potentially the first step toward what may be the inevitable floating of the Chinese currency, and that has major implications for US asset prices.
On Monday, July 22, an excerpt from a story by Market News International
titled "China June FX Position Highlights Outflow Threat" read as follows:
A net sale of foreign exchange by Chinese banks in June may have been the result of new rules on how banks manage their dollar positions, but it has sharpened concerns about capital outflows -- and a possible government response -- in the coming months.
Also on Monday, David Keohane over at the FT Alphaville
blog posted some interesting comments from Nomura and BAML about the impact QE tapering is going to have on liquidity in China.
The following is from BAML’s Bin Gao:
China will feel a more direct hit from the quantity side of QE tapering. Unlike most major economies, China relies on FX for base money creation, and this is reflected by the fact that 83% of the assets on the PBOC’s balance sheet are FX reserves, as of May 2013.
We do not want to overemphasize the effect that high US rates had on the money-market squeeze in June, but we also believe it would be a mistake to ignore the effect of Fed tapering its stimulus program on China’s onshore liquidity. There is a solid economic mechanism at work here. As the Fed’s tapering program helps the USD to gain its strength, reserve accumulation will slow down significantly and may even drop, running the PBOC’s money creation machine out of fuel as there will be less dollar to buy and less RMB to be put to work.
Then Keohane posits:
Of nearer term interest is what China can do to fight back against this liquidity withdrawal.
This is a big question.
I couldn’t locate the research piece from BAML’s Gao, but I did find an equally disturbing piece by BAML’s Asia macro team of Ting Lu, Xiaojia Zhi, and Larry Hu.
The following is from the June China Macro Weekly titled "Where Has All the Money Gone?"
Many investors seem concerned that the enlarging gap between credit growth and GDP growth could be the revelation of skeletons in the closet. Most accept that China’s potential GDP growth is inevitably slowing down due partially to its aging population, but why does it take faster credit growth to drive slowing economic growth? Are Chinese banks’ non-performing-loan ratios much higher than the headline 1%? Are there many more investment projects on life support which take on new credit merely for interest payments? Are speculative activities much more rampant than thought with credit used for non-value-generating activities?
Whatever the factors behind the divergence, the markets now seem to be wondering if China will have its own Minsky moment post the financial collapses in the US and Europe since 2007.
Yikes! They are not alone. Below if from Bloomberg
’s Simon Kennedy on June 21:
China may be approaching a “Minsky moment” -- a sudden fall in asset values bloated by credit.
Credit growth in the world’s most populous country has outstripped economic expansion for five quarters, raising the question of where the money has gone, Societe Generale SA economist Yao Wei wrote in two recent reports. In the first quarter, for example, bank loans, shadow banking credit and corporate bonds together accelerated more than 20% year-over-year, while gross domestic product grew less than half that much. The gap has been widening since early 2012.
Yao says the answer to where the money is going is a growing “debt snowball” which doesn’t contribute to economic activity. The result is both companies and the public sector face burgeoning interest expenses.
If China does see a Minsky moment, it will have been triggered by US monetary policy. On July 26, Kevin Ferry of Kronus Futures posted comments on his The Contrarian Corner
blog explaining the monetary policy regime change underway at the Fed, and I think this could have a profound impact on the situation in China and elsewhere. (It's in response to one of my old articles which I circulated on Friday, titled US Monetary Policy: On a Magic Carpet Ride
The increased discussion of the level of LSAP is actually the first step in turning the Fed back toward an interest rate target regime. Although pointed to as a speck on the Eurodollar Strip horizon, in the land of color coded packs, the market is exploring the possibility.
…our Market Rule has proved much better at determining the tilt of policy AND its future course. The Market Rule still projects a NEUTRAL (i.e. neither easy nor tight) Fed Funds rate of virtually NIL at this time…. The takeaway – that the Fed seems to grasp better than most – is that without LSAP policy would be NEUTRAL.
The trick going forward is to walk the market back to a rates regime AND keep the calibration appropriate to the forecasts and risks. In other words, the Fed is upping forward guidance and rhetoric hoping to create an aura of accommodation.
This is big. This is exactly what the bond market has been adjusting to with real interest rates pushing up nominal yields. The market is smarter than you think. With the Fed backing off its quantity regime via tapering and opting for guidance forecasting of the Fed funds rate, which, as Ferry’s model shows, is neutral, the inflation premium predicated on easy monetary policy is coming out of the market. As the inflation premium declines, real rates rise, the dollar strengthens, and the emerging market carry trade reverses. This is what is causing liquidity problems in China and other emerging markets like India and Brazil.
Brazil Vs. China CDS
If the Fed is moving from a quantity target to a rates target -- and I agree with Ferry -- the excess liquidity from QE is in the process of peaking, potentially for good. That means that the FX reserves that have flowed into emerging markets are also peaking for good. This capital flow reversal in and of itself is not necessarily the problem. The problem is how these respective monetary authorities deal with this potential contraction in liquidity. India has raised interest rates. China has lowered them. Brazil is selling dollars. Japan is buying them.
Back on July 17 in Bloomberg’s Economics Brief, Pierpont Securities Global Strategist Robert Sinche (formerly RBS’s FX strategist) wrote a commentary about the spread between spot CNY and the non-deliverable forward that was signaling yuan depreciation.
CNY Vs. NDF
Over recent weeks, the difference between the current spot dollar-yuan and the 12-month non-deliverable forward rate has hovered near its widest since flexibility was announced in 2005, save for a period of extreme market turmoil in late 2008. Over recent weeks the 12-month NDF has regularly discounted about a 2% depreciation of the yuan against the dollar over the next year.
There appear to be two main factors behind the shift in market expectations favoring a yuan depreciation. The first is fairly straightforward: a widening interest rate differential that, according to pricing of the forward market, implies a weakening yuan.
You can see that, up until 2012, the NDF consistently discounted a strengthening yuan (lower CNY). However, when the Fed opted for a balance-sheet neutral Operation Twist in the fall of 2011, it had a direct impact on China FX reserves, the forward value of the CNY, and in turn, their purchases of US Treasuries. Between September 2011 and 2012, China FX reserves barely grew, and their ownership of USTs dropped. Conversely when QE III was launched in 2012 China FX reserves increased and they picked back up their purchases of Treasuries.
China FX Reserves Vs. Fed Treasury Balance Sheet
As BAML suggests, the excess liquidity provided by LSAP is the fuel to the Chinese economy, and in turn, their cash created to finance our debt. The more the Fed buys, the more China buys. However, if the Fed is about to turn off the spigot, then China is going to need to find liquidity from someplace else. As the NDF suggests, that may be a weaker yuan.
Since China entered the WTO in 2001, the exchange rate situation has been one-way. The yuan is pegged to the dollar, and this subsidizes US import demand to the benefit of the Chinese export economy. The Chinese finance this consumption by purchasing our debt with dollars we export. This relationship worked pretty well up until the US financial crisis.
Since, the financial crisis GDP growth has been tepid and US consumption has waned. The rate of growth of personal consumption expenditures is now at 2.9% near the lowest in 50 years. This is a problem for export-driven economies because US consumers (namely, the baby boomers) are reducing consumption, which means reduced dollars imported into China. The implied strength in the CNY was a product of the USD import, but with fewer dollars flowing into China, that exchange-rate advantage weakens. Up until now, QE has made up the difference, but tapering is changing this dynamic. This could be another reason forwards are pricing in a weaker CNY.
Why should US investors care?
The Next Market Accident
The US largely externally finances its debt with foreigners owning roughly half of Treasuries outstanding. In September 2001, when China officially joined the WTO, they owned just $72 billion of the total $2.9 trillion in marketable outstanding US Treasury debt (2.5%). As a comparison, at that time Japan owned $300 billion. In July 2005 when they introduced the band to the CNY peg, China was up to $300 billion of $4.0 trillion (7.5%). Today China is the second largest holder behind the Federal Reserve and owns $1.3 trillion of the $11.3 trillion in marketable debt outstanding (11%).
Japan is the third largest holder of Treasuries, but since Abenomics began, the Japanese have curtailed their purchases of Treasuries. At the end of 2012, Japan owned $1.11 trillion, and as of May 2013 they still owned $1.11 trillion. Presumably Japan will continue to depreciate the yen, which means we should expect their appetite for Treasuries to continue to wane.
JPY Vs. Real 5-Year Yield
It’s not a coincidence that dollar asset demand is a function of the world’s reserve currency value. It’s purchasing power. The more USDs were exported around the world, the more purchasing power foreign currencies gained. For the past decade the JPY has appreciated against the USD, and the Japanese have been a big sponsor of our debt. This is why the USDJPY is so correlated with real interest rates. But with USD strengthening on the back of a rise in real interest rates, is that demand for US dollar assets about to change? You can see how there is a big feedback loop in play here. The higher real rates rise, the stronger the dollar becomes, which reduces foreign purchasing power for USD assets, which pushes rates higher.
When my bank’s management asks me what I think about the bond market and the future trajectory of interest rates, I always tell them what I think is going to happen based on fundamentals and then why it may not work out that way. My stock answer to the latter is that I worry about “accident” risk. By accident
I mean a fat-tail event that is out of our (the Fed’s) control and unrelated to economic fundamentals. The next accident could be the result of fallout from a float of the CNY because there is no way to handicap what that might mean for USD asset prices.
If you want to know what can go wrong, this is it. The PBOC floats CNY, which depreciates against the USD, providing China with less purchasing power with which to buy US debt. With the Fed ending tapering while both Japan and China devalue, you could potentially see the three largest purchasers of US Treasuries all pulling back from the market at the same time. It would be naive to assume that that would not elicit a severe reaction in the US bond market. In fact, it may already be happening.