The Renminbi Needs Ready Cash
Conventional wisdom is that China's biggest Trump risk is the introduction of hefty tariffs that would make Chinese exports uncompetitive. While trade issues make good media sound bites, a bigger danger — both for China and for financial markets' stability — is tax of another sort.
The US president-elect's campaign promise to change tax laws to reward American companies' repatriation of capital is casting long shadows over the renminbi.
The connection may not seem obvious. But Chinese policymakers have been wrestling (without much success) with the vicious cycle of rising capital outflows driving further renminbi devaluations, in turn driving even bigger and faster outflows.
US tax code changes that make it attractive to repatriate American capital are not good news for an economy that saw net outflows estimated at close to $1 trillion in 2015 and $500 billion in the first three quarters of this year.
China has been fighting outflows with two main tools: Supporting the renminbi exchange rate, and setting up new and bigger administrative firewalls to enforce its capital controls.
While China would not be dismayed to see a weaker currency provide its exporters with a much-needed boost, it definitely would not want panic in the markets. In the 11 trading days to Friday last week (November 18), both the onshore and offshore rates of the Chinese currency dropped by nearly 2% to their lowest against the dollar in more than eight years.
Keeping the renminbi from being seen as a one-way bet to the downside requires central bank intervention. But propping up a currency against the market is an expensive business. By one reckoning, China burnt through about half a trillion dollars in the 11 months to June this year to contain the panic selling.
Any new developments that make it attractive for capital to leave China would also deal a blow to the Chinese currency. Perhaps the promised tax change will never happen. Perhaps it is just campaign talk.
But China is not waiting around to find out. The chicken-and-egg relationship between capital outflows and a weak currency means that the Chinese government cannot rely solely on its administrative firewalls to prevent capital flight and panic in the market.
Not only is the Chinese central bank keeping its powder dry, it is making sure it is not waiting until the last minute to stock up.
The US Treasury market is liquid and deep but any large transactions would be quickly picked up by traders - moving prices to the seller's detriment. Liquidating large portfolios at the last minute is bad strategy.
Note the central bank's other purchases. China has been buying gold, which is as good as ready cash, in almost every month since July last year, even in months when prices were going up.
It has also been buying short-dated Japanese government securities to the tune of US$86.4 billion in the eight months through August this year. The paper all have maturities of a year or less.
China has already pared its holdings of US Treasuries to their lowest levels in four years. It is likely to further reduce its US Treasury holdings in the coming months in anticipation of a US interest rate rise and to be ready for sudden calls for ready cash.
The renminbi will continue weakening - and little has happened since September last year when I predicted Chinese currency depreciation to change my view.
I also believe that pent-up capital outflow pressures in China will worsen. Administrative firewalls won't work forever. But that's a story for another day.
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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.