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 Massive amounts of capital are leaving China, driven variously by
fears of a slowdown, of a falling yuan and of a corruption
crackdown, with some estimates putting the figure for 2015 at or
above $1 trillion.
As capital leaves, China’s foreign exchange reserve managers must
either sell some of the $3.3 trillion in assets they have stockpiled
or allow the yuan to weaken. As a weakening yuan, while helping
exports, can become a self-fulfilling spiral, China has resisted
allowing market forces to play their role.
"It's ridiculous. It's impossible," Han Jun, deputy director of the
office of the Chinese Communist Party's Leading Group on Financial
and Economic Affairs, said on Monday when asked about further falls
in the yuan.
"China still maintains a huge capital inflow," Han said, taking a
somewhat lonely position amidst evidence to the contrary.
China’s resolve to support the yuan implies further selling of U.S.
assets, particularly Treasuries but also corporate and other types
of debt. As bonds are sold, it will press yields higher than where
they would otherwise settle.
That’s not to say U.S. interest rates will go up; the overall impact
of China is clearly deflationary. Instead, the normal boost the
economy might get from falling Treasury yields will be blunted.
Treasuries, on some measures, had their strongest opening week of a
year ever in 2016, while stocks had their weakest. Yet Chinese
official selling may actually have capped bond price gains as well
as the fall in yields.
This also underscores the extent to which the Federal Reserve, which
raised interest rates for the first time in a decade in December,
faces challenges to its control over yields, which are its principal
means to steer the economy.
“In my view, the downside risks relate mostly to the influence of
the rest of the world on our economy,” Atlanta Federal Reserve
President Dennis Lockhart said on Monday.
“Last week we saw a global sell-off in stock markets apparently
triggered by data from China that fell short of expectations.”
Data last week showed China's foreign exchange reserves fell by the
most on record, $108 billion in December alone. Reserves dwindled by
more than half a trillion dollars for the year.
MASSIVE SALES
Bank of America Merrill Lynch estimates that China sold $292 billion
of U.S. Treasury debt last year as well as $3 billion of U.S. agency
bonds and $170 billion of non-U.S. assets. BAML on Monday predicted
that U.S. corporate bonds could prove vulnerable to Chinese sales.
China holds more than $400 billion of U.S. corporates, the bank
estimates.
Swap spreads, the extra that an investor gets for accepting a
floating payment from a bank rather than a Treasury yield, have
narrowed in recent weeks, a trend tied to Chinese selling. As of
Monday two-year swap spreads were down to nine basis points, as
compared to about 24 basis points a month ago.
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At various points last year swap spreads were actually negative, a
bizarre condition considering that banks are far riskier
counter-parties than the U.S. government.
To be sure, U.S. borrowing rates remain extremely low. Ten-year
Treasuries yield just 2.17 percent, and two-year notes only 0.93
percent.
This is really simply the flip-side of the phenomenon of Chinese
reserve accumulation over the last 15 years, a trend which arguably
also drove U.S. interest rates too low, despite Fed efforts. That
was one of the underlying causes of the U.S. housing bubble, and may
also have contributed to the earlier dotcom bubble, as investors
took on risk and borrowers found money too cheap not to borrow.
Still, it is important not to understate the extent to which China's
management of its foreign reserve assets can complicate U.S.
economic management, not to mention muddy the waters in global
financial markets.
China, a great importer of raw materials and exporter of finished
goods, is sending deflationary waves globally already. That China
might depress demand for U.S. products while at the same time, on
the margins, raising the cost of financing for dollar-based
borrowers only makes the Fed’s position more thorny.
Chinese selling of Treasuries and other fixed income will also tend
to up-end investor expectations of how their portfolios will perform
in times of market stress.
With no signs that capital flight pressure will diminish, China will
remain one of the main market and economic risks in coming months.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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