China Key Intelligence Question: What Is The Czar's 'Core' Strategy?

Includes: CNY, CYB, FCA, FXI
by: Adam Whitehead


President Xi Jinping's status is being elevated to mythical "core" status.

The "core" status is associated with its most significant leaders and the most significant changes in China.

China has signaled that it is ready for a global currency accord.

China has pegged the Yuan to the Dollar by stealth exchange controls.

Market consensus is moving to accept the premise of Chinese exchange controls and the pegging of the Yuan to the Dollar.


As emerging markets submerge and the Eurozone breaks apart, there are those who seek order and stability to come out of the chaos. China has been a major beneficiary of stability and order; and is now an alleged principle source of the chaos. Attempts at unilateral currency devaluation by nations have only triggered reciprocal behavior, which has added to the global instability. Clearly competitive devaluations are not the solution to the global imbalance issue. Analysts feel that a new accord on currencies ("Plaza II") is desirable. The recent entry of the yuan into the IMF SDR basket facilitates such an accord.

The problem is that there is no market consensus on whether the yuan should revalue higher or lower at this point. Policy makers, therefore, need to take the lead and frame market expectations. This, however, implies that policy makers themselves must have a consensus of where currencies should be and what each nation must do in terms of economic policy. President Xi Jinping's signal that he intends to take a more proactive role in economic policy decisions, suggests that China is ready to deal.

The Deputy Governor of the Indian central bank also seems to be of the opinion that a currency accord at the G20 level is needed. The I and C in the BRIC grouping are waving a white flag. The R in the BRICs remains belligerent, with the view that threats to global security are the best form of diplomacy. The B in the BRICs is in a hyperinflationary depression and facing a Zika virus pandemic. Whoever becomes the next managing director of the IMF, their first job will be to work on furthering an accord that involves the BRICs.

Unfortunately for President Xi, America is embarking on a presidential election process so that there is little chance of sincere reciprocation at present. In addition, the nation has become so partisan that it is hard to imagine a comprehensive agreement could be reached with such a dysfunctional irrational foreign policy actor. Europe is disintegrating under populism and moving into its own national election campaigns. The developed nations are, therefore, in no political shape to achieve an accord. The question, therefore, is whether the developed nations will allow the IMF to act as their proxy.

Perhaps sensing that now is not the time for a comprehensive accord because of the idiosyncrasies of the electoral systems in developed nations, Christine Lagarde proposed a short-term emergency stop gap initiative; to support emerging nations that are being pushed around by the lack of order in the global financial system. No doubt Lagarde is also concerned that she has not yet been re-elected to become managing director of the IMF. She cannot, therefore, prematurely anticipate a global accord that does not involve her. Neither can she afford to wait around however whilst the global economy goes into reverse.

Lagarde's stance was mirrored by Treasury Secretary Lew. Observing strict protocol, by talking directly to Deputy Premier Wang Yang, Lew continued to play hardball with the Chinese by asking them to clearly articulate their intentions and capabilities in relation to the yuan.

The last report looked at the growing conflict between President Xi Jinping and his Premier Li Keqiang; or at least the premier's policies. The report concluded that "the President is flexing his muscles for some as yet unknown purpose" and that "He is therefore on his way to become a Czar". This elevation process was further confirmed by recent reports that there is a political move to give the president the anointed title of "core". Such a move would elevate him to the status of the titans Mao Zedong and Deng Xiaoping. Such status is associated with major changes in Chinese policy, so the stage is set.

With his announced intentions and capabilities, to get more deeply involved in economic policy, the president is setting himself on a potential challenge to the economic reforms that Premier Li has initiated. One such reform that may be overturned is the move towards opening up the capital account, by imposing exchange controls. SocGen has speculated that this may, in fact, occur soon.

In the absence of capital flight, funds would be available to stimulate the domestic economy. The last report discussed the diminishing returns that China was seeing on its monetary and fiscal stimulus packages. Effectively imprisoning the stimulus within China through exchange controls would certainly amplify the effects on any stimulus package. The PBoC would also be able to reduce interest rates and expand monetary policy, without the fear of driving further capital flight. With more money imprisoned within China, the prospects for domestic inflation would therefore improve, which would then knock on to wage growth. Equity and real estate markets would also reverse their slide because there would be no external alternative assets to speculate on.

Foreign policy makers would also be happy because China would then be exporting inflation rather than the current deflation. This export of inflation would then give developed nation central bankers a better chance of hitting their 2% inflation targets. It will be interesting to see if the IMF makes another infamous exception to its rules about open economies, in order to accommodate imminent global economic expediency by opining that China should impose exchange controls.

The attractions of capital controls are seductive but it would provide a big loss of faith for the Chinese government, which has prided itself on flexing its global credentials. What would be needed is a traditional "useful idiot" in the ranks of the elite to blame for the failings of the rush to open the economy. Premier Li could be that guy. The interjection of the president into his premier's economic policy portfolio should have put Mr. Li on watch.

Recent policy moves by the PBoC can be placed into the context of an environment in which some kind of exchange controls will be implemented. In the latest round of targeted monetary stimulus, the PBoC cut down payment requirements for specific borrowers; in order to stimulate the property market whilst keeping it affordable and away from bubble valuations.

Potential bubbles from a future expansion of liquidity within an environment of exchange controls were addressed in the latest moves to tighten control of shadow banking in the wealth management sector. Limits were placed on the size of funds that can be raised in wealth management products. Third party management of pooled raised funds was prohibited. Finally, leverage of pooled investment funds will now be controlled.

The knee jerk reaction from within the financial services industry was to say that the PBoC's new shadow banking moves will exacerbate the current sell-off in financial assets. Industry professionals do not foresee that the control of bubbles in financial assets through rules and regulations is exactly the precursor condition required before a major stimulus of some kind is rolled out. The probability that a further monetary stimulus, combined with some form of exchange control, will be rolled out in the near future has now been raised. The recent silence of the PBoC governor Zhu Xiaochuan, noted in the last report, also suggests that something is coming.

A story that appears to contradict the thesis on exchange controls was also leaked to coincide with the official announcements of growth targets and shadow banking controls. Exchange controls are allegedly going to be liberalized even sooner on foreign investment. Allegedly "Qualified Foreign Institutional Investors" (QFII) will soon be allowed to invest and withdraw funds without any constraints.

On the face of it, things look as though they are being liberalized. They are, however, only being liberalized if one is a QFII. Anyone who is not a QFII will, therefore, face exchange controls. China will, therefore, tighten exchange controls by appearing to liberalize them. Investors who are not QFII's will have to wait in line, on the way in to achieving QFII status. Investors who are not QFII's who already have money in the country will be breaking the law if they take it out.

As was noted above, control of the shadow banking sector has been tightened and third party asset managers have been banned. These shadow banking rule adjustments should, therefore, be seen as the context into which the new QFII rules will apply. Shadow bankers who aren't QFII's will be put out of business; and hence all capital flows in relation to them will be choked off.

The eponymous State Administration of Foreign Exchange (SAFE), has recently had new head called Pan Gongsheng appointed. It would seem that this change at the top also signals a change in attitude towards the exchange rate. Mr. Pan's recent comments on the exchange rate signaled an intention to prevent further depreciation. He did however rule out currency controls explicitly. It seems that stealth currency controls rather than explicit ones will be applied.

Click to enlarge

(Source: Financial Review - link)

Thanks to Seeking Alpha contributor Christopher Flens-Batina further evidence of "capital controls by stealth" in existence since late 2015 have also been found. The PBoC has been trying to close down what is referred to by the PBoC as the "arbitrage trade". The "arbitrage" has allowed money to be moved abroad via the Hong Kong interbank foreign exchange market. According to PBoC sources, the Governor directed them to clamp down on the "arbitrage trade". Counterparties wishing to move more than $50 million out of China must have an interview with the PBoC. This begs the question of what fifty people who all move $1 million have to transfer do. However, the PBoC's intent is clear.

When it was read that BOJ Governor Kuroda advocates that China should apply exchange controls, this was initially taken with a large grain of salt. Kuroda was clearly talking his own book on the exchange rate with the Yen. There is, however, growing evidence that exchange controls are either being considered or actually being applied through stealth.

Click to enlarge

(Source: Seeking Alpha)

Thus far, this series of reports has led to the conclusion that the PBoC is pegging the yuan back to the US dollar. This is being done not only to arrest the capital flight, but also to hitch a ride to the potential for the US dollar to weaken; now that the prospects for significant interest rate increases by the Fed diminishes, as the US economy succumbs to the global headwinds.

Click to enlarge

(Source: Bloomberg)

Chinese policy makers can see how bad things are at home; and, therefore, surmise that this will translate into American economic weakness in the near future. The recent market intelligence about the "capital controls by stealth" not only supports the pegging hypothesis, but puts it into a deeper strategic context.

Click to enlarge

(Source: Bloomberg)

There is now also a growing debate in the public domain over whether China is in fact betting on a weaker US dollar. This is not only evidence of support for the US dollar peg thesis, but also evidence of a wider discussion that may lead to a global currency accord. Goldman in particular is anticipating some kind of global shift in attitude towards the yuan.

The announcement by the National Development and Reform Commission Chairman Xu Shaoshi, that the new economic growth target range is 6.5% to 7% also suggests that some major policy initiatives are to be made soon. President Xi Jinping has set his own personal target to double the GDP of 2010 by 2020. Backing out the data from this target, the economy needs to average a growth rate of 6.5% per annum. Many sources estimate that it is growing well below this required average rate. If President Xi doesn't act soon, to get ahead of his hypothetical moving average, he will fall further behind the curve.

All these policy announcements (and leaks) come after the president has made it known that he will become more involved in economic policy. Can there be any doubt that these latest policy initiatives have come from him?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.