The Chinese Corridor

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Includes: CNY, CYB, DIA, IWM, QQQ, SPY
by: Ben Emons

Summary

Recently, the People's Bank of China (PBoC) announced to consider a "corridor system" for managing interest rates.

The "Chinese Corridor" is about managing interest rates of onshore currency - "CNY"- and offshore currency - "CNH."

CNY is likely to be more freely floating than (crawling) pegged. This has made the probability of a global and U.S. recession greater, and thereby deeper negative interest rates.

Recently, the People's Bank of China (PBoC) announced to consider a "corridor system" for managing interest rates. A corridor system is a symmetric channel for monetary policy implementation. Such systems are used, for example, by the European Central Bank (ECB) and now (implicitly) by the Federal Reserve. Key features of a symmetric channel system are standing central bank facilities that lend to and accept deposits from commercial banks. The lending facility resembles the discount window, and the deposit facility allows banks to earn overnight interest on excess reserves. The interest rates at the two standing facilities form a "channel" around the target rate.

The "Chinese Corridor" is about managing interest rates of onshore currency - "CNY" - and offshore currency - "CNH." To stabilize the relationship between CNY and CNH, there are two central banks involved that manage the yuan onshore and offshore interest rate differential. The PBoC sets onshore interest rates for Chinese banks by changing the reserve requirement ratio on yuan deposits, and by changing the rate on its Standing and Medium Term Lending Facility (SLF, MLF, credit line and low cost funding to domestic banks). The rate on the domestic lending facility acts as the "onshore ceiling."

The "floor", on the other hand, is somewhat complicated. Traditionally, the floor in a corridor system is the interest on excess bank reserves. This is, for example, the CHIRER Index as published by the PBoC. However, because of the structure of the onshore and offshore market in Renminbi (CNY and CNH), yuan interest rates in Hong Kong act as the "offshore floor." These interest rates are implied by CNH currency, and they vary based on supply and demand of yuan in the offshore market in Hong Kong. As such, the actual "floor" for China's corridor is the difference between onshore and offshore interest rate, namely SHIBOR (CNY Libor rate) and HIBOR (CNH Libor rate).

For a while, the interest rate difference between CNY and CNH didn't matter so much. Nowadays, it is an important gauge for capital flows from China, and thereby, for capital flows globally. Capital flows to and from China are hard to estimate but they are driven by several distinct factors. First source of capital flight is China's "shadow banking" system. This system refers to non-bank financing, encompassing trust and wealth management products, entrusted loans, and bankers' acceptance bills. The shadow banking system is currently around 9 trillion CNY (~$2.7 trillion) in size. The shadow banking system is tied to the stock market through wealth management products. As Hugangtong (Trading channel between Shanghai and Hong Kong stock exchanges) was carried out, significant wealth management (capital) flows to and from mainland China happened in domestic and Hong Kong stock markets.

The second source for capital flows is onshore and offshore corporate bond issuance and yuan loans issued by Chinese state owned trade companies and domestic banks. This debt has reached a total of $3 trillion and includes debt from Chinese companies in Hong Kong and Taiwan. The debt creation in dollars by these companies was mainly driven by CNY appreciation between 2010 and 2014. The yuan's appreciation prompted Chinese companies to borrow dollars offshore and use the money to profit from a strong CNY currency and higher interest rates in China. This has resulted in growth of total debt - government, household and corporate - by 12 percent of GDP in 2015. Just in January of this year, new yuan loans surged to 2.51 trillion yuan, while onshore bond issuance has reached 2.8 trillion yuan, both aimed at repaying dollar debt. The surge in onshore borrowing caused dollar denominated borrowing to drop by about $140 billion in the second half of 2015 to $1.69 trillion. This drop has been linked to Chinese residents buying foreign currencies that amounted to total capital outflows of $1 trillion for 2015 entirely.

Since the middle of 2014, capital outflows accelerated. This has been driven by Chinese trade and shipping companies struggling to pay dollar debt against rising labor costs and falling commodity prices, unwinding of wealth management products as the Chinese stock market crashed, and (creeping) defaults on trust loans (Credit Equals Gold # 1 for example). The acceleration in capital outflows has impacted the difference between onshore and offshore interest rates quite dramatically. Currently the difference between onshore and offshore rates is -6%.

This trend in capital flows has become the key characteristic of the "Chinese Corridor" system. A further widening of the interest rate differential as result of overly loose Chinese domestic monetary policy weakening CNY, and an overly tight Hong Kong monetary policy because of Hong Kong dollar peg to an appreciating US dollar, spurs capital outflows. This policy stance has impacted negatively the Chinese "carry trade" by borrowing in dollars and reinvesting in China or high yielding emerging markets. The size of the carry trade can be gauged from the Bank of International Settlements estimates of consolidated foreign claims on China. Those have plunged by 27 percent through September 2015, from $857.7 billion record in June 2014. CNY is expected to gradually depreciate further as implied by CNY FX forwards, by about 4 percent in 1-year from today. A simple historical relationship shows for every 1 percent of CNY depreciation, commodity prices have fallen by 10 percent, and capital outflows from China amounted to $500 billion. This CNY depreciation rule of thumb had dramatic effects on global equity, credit and Treasury markets.

It has been said the Federal Reserve acts as the "central bank of the world" but the same can be said of the PBoC. Its policy at steering CNY versus CNH has caused uncertainty about the boundary of CNY depreciation. As much as China can tighten controls over capital flows from domestic residents, Chinese companies abroad that account for half of the Chinese corporate dollar debt, cannot be controlled. Chinese mainland residents and abroad cannot be stopped from buying dollars either. The proposed corridor system by the PBoC is therefore an important policy tool to control capital flows. It is however an asymmetric system. By setting a hard ceiling on lending domestically, the PBoC cannot set a hard "floor" because of unpredictable capital flows and speculation on the CNY and CNH. The floor - measured by the interest rate difference between CNY and CNH - is directly correlated with monetary policy actions from major developed market central banks. The more negative the CNY-CNH interest differential becomes, the more capital outflows happen which causes global uncertainty. This has in response seen more policy actions in the form of QE and negative interest rates by central banks in Europe and Japan, and now potentially the U.S.

The implications of the Chinese Corridor is the carry trade is likely to unwind further despite the PBoC attempts with liquidity injections ($25 billion of 163 billion CNY was pumped in the system on Friday). The Chinese Corridor system may temporarily stabilize CNY, but the pace of CNY depreciation is now determining how monetary policy should be conducted in other countries. A reversal of the recent market turmoil and capital flight can only be established if the floor of the Chinese corridor becomes "harder." This can only be the case if CNH and CNY are pegged to the dollar. Because of the significant deleveraging by Chinese state owned trade, shipping and bank companies, CNY is likely to be more freely floating than (crawling) pegged. This has made the probability of a global and U.S recession greater, and thereby deeper negative interest rates and reversal of Fed tightening potentially more likely. As such, the Chinese Corridor is now the setter of global monetary policy.

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.