Chitchat Don't Bet On The Wrong Horse: The Coming Economic Woes of China!

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An honorable member of the Coffee Shop Has Just Posted the Following:

Further reform needed to solve China’s capital outflow

Concerns about China's capital outflows and plunging yuan have been exacerbated by warnings from various international investment banks. The accuracy of these warnings aside, China's monetary authorities should avoid intervening in the currency market, otherwise it will reinforce the expectation of the yuan's unilateral depreciation and risk triggering an adverse feedback loop between weakening yuan and capital flight.

Goldman Sachs recently warned that China's capital outflows may be worse than they appear and indicated that November saw a net of $69.2 billion flow out of the country, compared with the monthly average of $50 billion since June. Barclays put the net capital outflow in the third quarter of the year at "a near-record" of $207 billion.

Views on the volume of China's capital outflows have long been divided. But the country's balance of payments data, which is calculated based on IMF standards, better reflects the movement of capital flows. The latest balance of payments data showed that the country continues to see two-way volatility in cross-border capital flows, alternating between inflows and outflows.

But no matter what metric is adopted to calculate the capital flows, it is almost certain that there has been a greater tendency toward net capital outflows in the last two years. For one thing, Chinese residents currently hold more overseas assets than in previous years. In addition, Chinese assets held by nonresidents are declining and lots of companies are even selling off their assets in China. Of the two, the latter has had a greater impact on changes to capital flows.

So why are firms and overseas investors reducing their yuan holdings more so than in the past? Economic fundamentals cannot fully explain the recent accelerated capital outflows. Even though there have been upward and downward cycles of economic activity as well as periods of a stronger and weaker dollar, these cycles have occurred previously without the accelerated capital outflows we are now seeing.

I tend to believe that it is the expectation of the yuan's unilateral depreciation that is motivating this reduction in yuan assets. The expectation signals risk and thus reducing yuan assets is not unreasonable as investors are obligated to hedge against exposure and keep corporate operations on a sound track. The anticipation of unilateral depreciation, which is at the center of concern for domestic residents, firms and overseas investors, creates a risky feedback loop where expectations of yuan depreciation trigger capital flight, which in turn exacerbates depreciation worries and adds greater pressure on the yuan.

This feedback loop is caused by market intervention. To stabilize market expectations and stem capital outflows, the monetary authorities should break the loop by allowing the market to move in such a way as to clear itself through price changes and reach an equilibrium. Many monetary authorities in the world have a strong desire to intervene in the currency market and non-intervention does not exist in absolute terms. The key is in not making intervention a common practice but in allowing the market to self-correct.

Given the Fed's projection of three rate hikes next year, the pressure of yuan depreciation will continue to persist and grow. The situation requires that China's central bank reforms the yuan's exchange rate formation mechanism. In fact, China kicked off a reform to change the calculation method of the yuan central parity rate in August 2015 to make the currency's value more dependent on market movements. The implication of the reform on the market is undisputable but it needs to be carried through. China cannot allow the reform to reverse or erode. Based on the experience of other countries that have heavily intervened in their currency market, doing so yields no desirable results.

A breakthrough in the yuan's exchange rate formation mechanism is needed to reduce intervention and rationalize market expectation. In doing so, even if the Fed's rate hikes do add pressure on the value of the yuan, this won't trigger massive capital flight, which will actually benefit China's economy.


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