A Hot Money Flight Developing In China?

Includes: DIA, SPY
by: Russ Winter

China is beginning to experience a capital run. In part, this is a product of the end of that country's surplus-based export economy, which has been slowing for more than a year. This has variously been described as "demand for dollars" or a dollar squeeze. In reality, that reflects money borrowed in dollars and is being paid back at a time when the Yuan is dicey. Like all speculative binges, this one was based on borrowing in foreign currencies, including Hong Kong, Taiwan and U.S. Dollars, and suddenly the music stopped [U.S. Dollar Funding Drying Up].

May 21 (Bloomberg) - [U.S.] Dollar-denominated deposits in China are rising at the fastest pace in at least five years and government debt is rallying, reflecting waning confidence in the world's second-biggest economy. Foreign-currency deposits increased $89.4 billion in the last four months to $364.5 billion, the biggest jump in data going back to 2007, People's Bank of China figures show.

(Click to enlarge)

Of course, China has no shortage of dollars. It is simply in the wrong places and locked up by the PBoC in U.S. Treasuries. It's a mismatch between China's substantial longer-duration dollar assets and China's substantial short-term dollar liabilities.

"The unnerving part of this is that as demand for dollars rises, the central bank even has to sell dollars in the market to meet such demand," said Li Wei, an economist at Standard Chartered Plc in Shanghai. "April's forex sales indicate that the central bank has already drastically reduced its intervention in trading."

The real game changer is not necessarily the PBoC's new tendency to sell Treasuries to meet short-term dollar liabilities demand. It's the risk that the VIP, elite crowd in China pulls the plug in a capital flight out of China. Victor Shih from Northwestern University raised this very real prospect in his 2011 paper by pointing out that the wealthiest 1% of households in China commands wealth that is at least as large as two-thirds of the foreign exchange reserve and possibly as high as nearly twice its size. Thus, if the top 2 million households in a nation of 1.3 billion people decide to move even 30% of their wealth overseas, the foreign exchange reserve will reduce by a trillion dollars or more.

Of course China does have capital controls to prevent a massive flight, but there are ways around it. [Why are Chinese Buying Record Quantities of Gold?]

"If you have the political connections in China, it's quite easy to get away with these things," says Borge Bakken, professor of criminology at the University of Hong Kong. "There are thousands of ways to get money out of the country."

Indeed there are increasing signs that confidence among the Chinese financial elite is waning and an inflection point building. Even beyond poor business conditions in country, a glance at China's disastrous real estate bubble says it all about hot money staying around.

A clue to sentiment comes from high roller junkets to Macau, which have been waning since last summer. A China Daily story states that 60% of China's rich want to emigrate. The real problem, are those who follow the 'smart money,' China's wealthiest 1%.

Victror Shih says, "Sizeable outflows from the smart money would see the remaining 9% of top 10% of households follow the smart money."

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