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Why China's Liquidity Crisis Could Lead to a Perfect Storm in the US Bond Market

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QE tapering is changing the dynamic between the US dollar and the Chinese yuan. Here's where the shift could take us.

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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.
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