Two people look towards high-rise buildings in Kowloon, Hong Kong, in a file photo. The Hong Kong Monetary Authority and Beijing have agreed to launch a cross-border bond connect, granting foreign investors access to the Chinese onshore bond market. (Antony Dickson/AFP/Getty Images)Two people look towards high-rise buildings in Kowloon, Hong Kong, in a file photo. The Hong Kong Monetary Authority and Beijing have agreed to launch a cross-border bond connect, granting foreign investors access to the Chinese onshore bond market. (Antony Dickson/AFP/Getty Images)

Beijing and Hong Kong have approved a new cross-border bond trading program, called bond connect, hoping to attract a new wave of foreign investors to buy Chinese onshore bonds.

The platform is similar in theory but differs in execution to the existing stock connect between Hong Kong and the mainland, which allows foreign investors to purchase mainland stocks. The bond connect will link Hong Kong to Shenzhen’s bond markets and is expected to go live on July 1, the 20th anniversary of Hong Kong’s handover to China.

Beijing hopes the bond connect will legitimize its bond market on the global stage and help diversify bearers of onshore default risk. But immediate success is unlikely, given the existing lukewarm reception of the similar stock connect program and overall investor skepticism of Chinese credit.

Expanding Access

China is the world’s third largest bond market following the United States and Japan, but is largely closed off from foreign investors. It first opened the onshore bond market to foreign investors in February 2016. Under this arrangement, foreign asset managers wishing to purchase such bonds must register locally in mainland China.

The bond connect will officially eliminate that requirement, as firms in Hong Kong will have the ability to purchase onshore bonds at will, without a mainland license.

In a joint statement May 16, the People’s Bank of China (PBoC) and Hong Kong Monetary Authority (HKMA) said that “Northbound trading will commence first in the initial phase, i.e. overseas investors from Hong Kong and other countries and areas (overseas investors) to invest in the China Interbank Bond Market.” The opposite southbound trading, or mainland investors investing in Hong Kong bonds, will commence in the second phase at a later date.


China is the world’s No. 3 bond market (Source: Oppenheimer Funds)

In theory, bond connect will no doubt expand the market for Chinese onshore bonds and bring in a new wave of investors. “The major advantages of the Bond Connect compared to the existing China Interbank Bond Market scheme are the speed of gaining the access and the fewer onshore account set up needed,” Gregory Suen, investment director of fixed income at HSBC Global Asset Management, told industry publication Fund Selector Asia.

Today, prior to the bond connect, about 473 foreign investment firms are active within China’s onshore bond market with investments totaling 800 billion yuan ($117 billion), according to PBoC estimates. However, the true number of foreign firms holding Chinese debt is less than the official figures, as about 200 of the 473 are investors from the Chinese territory of Hong Kong, which Beijing deems foreign.

To cater to the anticipated trade flow, the Hong Kong Exchanges and Clearing and China Foreign Exchange Trade System formed a joint venture on June 7 called the Bond Connect Company to offer trading and support services to market participants of the bond connect.

‘Not a Case of Build It and They Will Come’

Beijing hopes demand for bond connect from foreign institutional investors will exceed the lackluster enthusiasm investors currently have for the Hong Kong-Shenzhen stock connection, where trading activity remains tepid.

But that’s far from a certainty.

The Hong Kong-Shenzhen stock connect has been open for six months, but logistical and demand issues remain. Clearing and settlement differences between Shenzhen and Hong Kong regulators have caused a sizable portion of trades to fail in recent months, according to a South China Morning Post report. In addition, foreign demand for Shenzhen stocks so far hasn’t met Beijing’s expectations, with the technology-heavy Shenzhen issuers viewed as perhaps too risky for foreign investors.

It’s difficult to see bonds faring better. Despite Beijing’s opening up the domestic bond market to foreign investors last February—with no approval necessary as long as the investor has a local registered entity—foreign ownership of China’s bond market remains tiny.

At the end of 2016, foreign holdings of onshore bonds are only 1.3 percent of total market value, according to estimates from the Financial Times

That means investors don’t believe the investment returns on Chinese bonds are enough to justify the heightened default risk of owning Chinese debt, which has fueled much of China’s recent economic growth and today sits at almost 260 percent of GDP, according to ratings agency Moody’s Investors Service.  

Looking past macro issues, individual bonds are also notoriously hard to evaluate for foreign investors.

The industry standard global credit rating agencies of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are barred from operating in China. Chinese bonds are instead rated by domestic ratings agencies, which are viewed by foreign investors with distrust for granting overly generous credit ratings. In other words, it’s difficult to assess the credit-worthiness of Chinese issuers because information on bonds is unreliable.


Investors believe Chinese domestic credit rating agencies have tendencies to give out overly generous ratings to bond issuers (Oppenheimer Funds).

“For foreign investors, it’s not a case of build it and they will come,” concluded Rachel Ziemba, Managing Director at Roubini Global Economics, on CNBC. “They want to understand, they want to be paid for the risks they are taking on. In an environment where interest rates are rising in China, where the property market is flattening out a bit, that question mark about more information and drivers is going to be very important.”

The new U.S.-China trade deal signed during Chinese Communist Party leader Xi Jinping’s visit with U.S. President Donald Trump in April outlined a path for the U.S. credit rating agencies to begin operations in China later this year.

To foreign investors, that’s a step in the right direction, while also introducing new challenges. Foreign credit agencies will operate under supervision of Chinese securities regulators. During times of economic duress, can they remain independent and objective?

Read the full article here

An investor looks at an electronic board showing stock information at a brokerage house in Shanghai on March 16, 2017. (Johannes Eisele/AFP/Getty Images)An investor looks at an electronic board showing stock information at a brokerage house in Shanghai on March 16, 2017. (Johannes Eisele/AFP/Getty Images)

China’s new impetus to rein in its financial sector has been underway for more than three months. The effects are already being felt in the financial markets, impacting short-term borrowing rates and the global commodities market.

In late February, Guo Shuqing was appointed the new chairman of the China Banking Regulatory Commission (CBRC), China’s main banking regulator. Barely a month into his role, Guo issued a flurry of directives described by state-controlled Xinhua as a “strong supervisory storm.”

Guo, 60, is widely seen as a tough regulator willing to challenge financial heavyweights. His predecessor, Shang Fulin, was focused more on maintaining order and stability and did little to assert control over the financial sector, which has grown fat on China’s debt binge in recent years.

The CBRC’s new directives arrive as Chinese Communist Party leader Xi Jinping shifts his anti-corruption focus to the financial sector. Last month, Xiang Junbo, former head of the China Insurance Regulatory Commission, was put under investigation. Sources close to Zhongnanhai—the headquarters of the Communist Party and the State Council—told The Epoch Times last month that there could be further housecleaning within China’s financial industry this year.

Several of the new policy directives from the CBRC aim to deleverage the country’s banking sector. Two main goals are to reduce shadow banking—an umbrella term used to describe various high-yield products sold by banks, insurance companies, and other financial institutions—and to tighten credit.

Shadow Banking Targeted

Shadow banking and other off-balance-sheet credit activities fueled much of China’s recent debt growth, especially by regional and local banks. The biggest type of shadow banking is the sale of wealth management products, which are issued by non-bank entities such as trusts, investment vehicles, or insurance companies but often sold by banks.


Ratio of asset management products to total bank assets by type. (Source: Moody’s Investors Service)

Such products, which circumvent typical lending rules and do not sit on bank balance sheets, have been a critical income source for banks, and often represent the only avenue of financing available for small businesses, local agencies, and ventures that cannot qualify for loans from big state-owned banks.

Off-balance sheet wealth management products totaled 26 trillion yuan ($3.8 trillion) at the end of 2016, an increase of 30 percent from the previous year, according to data from the People’s Bank of China, China’s central bank.

In early February, China unveiled the first coordinated approach to regulate shadow banking. The People’s Bank, the CBRC, and regulators of the insurance and securities industries drafted a joint regulatory framework to tighten supervision of all investment products sold to retail and institutional investors.

Off-balance sheet wealth management products totaled $3.8 trillion at the end of 2016.

This coordination is significant as “previous efforts to regulate the asset management industry have emanated from individual regulators and created opportunities for regulatory arbitrage,” said Moody’s Investors Service, in a Feb. 27 note. In other words, China’s fragmented regulatory framework often allowed banks to sell wealth management products that fall under the jurisdiction of a different regulator—with lower standards—than their underlying assets.

Guo Shuqing, Chairman of the China Banking Regulatory Commission, answers media questions in Beijing on March 8, 2015. (Feng Li/Getty Images)

Guo Shuqing, Chairman of the China Banking Regulatory Commission, answers media questions in Beijing on March 8, 2015. (Feng Li/Getty Images)

A few of the tools introduced by regulators this year include barring the sale of wealth management products derived from non-standard assets other than stocks, bond, and money-market securities and applying a leverage limit across asset classes. One way banks had to boost the interest on wealth management products was to borrow money, and this risky practice will now be curbed.

Short-Term Liquidity Squeeze

Regulators are also targeting the loosely regulated interbank market that allows banks to lend to each other.

The People’s Bank is achieving this by reducing the amount of liquidity available to banks. After skipping open market operations—where the central bank buys or sells government securities—on May 2, it did not renew the 230 billion yuan lending facility, which matured on May 3. Overall, the People’s Bank injected a net 10 billion yuan ($1.5 billion) into the market, a minuscule amount compared to past weeks.

The recent tightening moves have pushed up short-term borrowing rates. The overnight Shanghai Interbank Offered Rate (Shibor) reached 2.83 percent, while the seven-day Shibor reached 2.92 percent on May 5. Those were the highest rates since April 2015.

“We expect liquidity to remain volatile and financial deleveraging to continue, with more ‘mini hikes’ in market rates and tighter new regulations,” wrote Deutsche Bank, in a March note.



Recent Shibor trends reflect tightening of credit (Source: Nomura Securities)

Slowing Economic Growth

The higher funding costs could have real-world economic implications, such as lower availability of credit for businesses and, ultimately, slower GDP growth.

But it’s likely that the official 6.9 percent GDP growth in the first quarter—above most economic forecasts—has given regulators room to curtail credit growth and still attain Beijing’s 2017 annual growth goal of 6.5 percent.

Chinese stocks have languished in recent weeks due to lowered expected future growth. The Shanghai Composite Index trailed other major global indices over the last 30 days, with a decline of 5.4 percent.

More regulatory clampdown may be on the horizon.

The global commodities market—especially sensitive to Chinese demand—has felt the biggest impact. Brent crude was down almost 11 percent over the 30 days ending May 5. Prices of iron ore, copper, and coal futures were also lower over the same period. Iron ore traded on the Dalian Commodity Exchange and hot-rolled coil and steel rebar traded on the Shanghai Futures Exchange plunged by their daily respective maximum allowed rates on May 3.

More regulatory clampdown may be on the horizon. A new rumor is circulating that Guo, the hawkish head of the CBRC, may soon take over as chief of a newly formed super-regulator, the amalgamation of current regulators for the banking, securities and insurance industries, according to the South China Morning Post.

For the Chinese financial industry and global investors, all signs point to further market volatility ahead.

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International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, April 20, 2013. (Stephen Jaffe/IMF via Getty Images)International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, April 20, 2013. (Stephen Jaffe/IMF via Getty Images)

When Bloomberg reported late last year that China founded a working group to explore the use of the supranational Special Drawing Rights (SDR) currency, nobody took heed. 

Now in August of 2016, we are very close to the first SDR issuance of the private sector since the 1980s.

Opinion pieces in the media and speculation by informed sources prepared us for the launch of an instrument most people don’t know about earlier in 2016. Then the International Monetary Fund (IMF) itself published a paper discussing the use of private sector SDRs in July and a Chinese central bank official confirmed an international development organization would soon issue SDR bonds in China, according to Chinese media Caixin.

Caixin now confirmed which organization exactly will issue the bonds and when: The World Bank and the China Development Bank will issue private sector or “M” SDR in August.

The so-called SDR are an IMF construct of actual currencies, right now the euro, yen, dollar, and pound. It made news last year when the Chinese renminbi was also admitted, although it won’t formally be part of the basket until October 1st of this year.

How much? Nikkei Asian Review reports the volume will be between $300 and $800 million and some Japanese banks are interested in taking up a stake. According to Nikkei some other Chinese banks are also planning to issue SDR bonds. One of them could be the Industrial and Commercial Bank of China (ICBC) according to Chinese website

The IMF experimented with these M-SDRs in the 1970s and 1980s when banks had SDR 5-7 billion in deposits and companies had issued SDR 563 million in bonds. A paltry amount, but the concept worked in practice. 

The G20 finance ministers confirmed they will push this issue, despite private sector reluctance to use these instruments. In their communiqué released after their meeting in China on July 24:  

“We support examination of the broader use of the SDR, such as broader publication of accounts and statistics in the SDR and the potential issuance of SDR-denominated bonds, as a way to enhance resilience [of the financial system].”

They are following the advice of governor of the People’s Bank of China (PBOC),  Zhou Xiaochuan, although a bit late. Already in 2009 he called for nothing less than a new world reserve currency.

“Special consideration should be given to giving the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency,” wrote Zhou. 

Seven years later, it looks like he wasn’t joking. 

Follow Valentin on Twitter: @vxschmid

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A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)

He was right about subprime, right about gold, and early in his call for a Japanese crisis. Is Texan investor Kyle Bass too early in his call for a China banking crisis and currency devaluation within the next two years?

“It’s a foregone conclusion but we don’t know about the timing, it feels like it’s happening as we speak,” he told Grant Williams of RealVisionTV in an interview. Bass had first stated his pessimistic view of China in late 2015 when the currency was under pressure and the country was bleeding capital to the tune of $100 billion per month.

Since February of this year and so-called Shanghai Accord or the G20 finance ministers, outflows have abated, although the currency has declined to a multi-year low of 6.66 per U.S. dollar.

There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system.

— Kyle Bass, Hayman Capital
The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

So why does Bass think the situation in China is intensifying? Everybody knows China has too much debt, especially corporate debt. As a result, the country’s total debt to GDP ratio is higher than 250 percent according to a range of different estimates. This is not much higher than Japan’s government debt ratio of 245 percent of GDP, so why focus on China now?

“The Chinese corporate bond market is freezing up. Since April 11th the Chinese corporate bond markets had 150 cancellations out of 210 announced deals,” says Bass. And indeed, the Chinese corporate bond market, which has helped keep unsustainable corporate debt afloat and also backs trillions in repackaged loans called Wealth Management Products (WMP) is in trouble in 2016.

Source: McKinsey

Source: McKinsey

According to Bloomberg, Chinese companies raised 1.85 trillion yuan ($280 billion) of onshore bonds between April and July this year, 30 percent less compared to the three preceding months.

Bankruptcies are also on the rise. Although corporate defaults are still in the low double digits, Chinese courts handled 1028 bankruptcy cases in the first quarter of 2016, up 52.5 percent compared to a year earlier.

“There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system. There are things that go on in those systems that show you there are problems,” says Bass, emphasizing the acuteness of these problems. “We see it starting now.”

While there are clear parallels to what happened in the United States in 2008 and Europe in 2010, Bass says that China’s problems are a magnitude larger. “They have asset liability mismatches in wealth management products that are more than 10 percent of their system. Our mismatches were 2.5 percent of the system and you know what they did,” he says. 

According to Bass, the bad loans will first hit the banking system and then lead to a sharp devaluation of the Chinese yuan. 

“How they deal with this, it’s not armageddon. They are going to recap the banks, the are going to expand the People’s Bank of China’s (PBOC)  balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going tot do everything the United States did in our crisis,” he said.


All of these policy measures would lead to a depreciating currency all other things being equal. But China’s currency is already under pressure as mostly Chinese citizens are taking their money out of the country because they don’t trust the banking system any longer. Bass estimates that bad loans could lead to losses of up to $3 trillion or 30 percent of GDP. Chinese citizens’ savings are backing these loans and they don’t want to wait around to find out whether Bass’s number is correct or not.  “In China, the credit excesses are already built in,” says Bass. 

They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.

— Kyle Bass, Hayman Capital

Goldman Sachs estimated that net capital outflows from China in the first quarter of 2016 were around $123 billion according to a report, 70 percent of which came from Chinese citizens funneling money out of the country. They do this in spite of harsher capital controls in 2016 and use either illicit methods like smuggling or legal ones like buying up Vancouver and New York real estate.

According to Bass, there is no way out for the regime, which is trying to manage the devaluation as much as it can. “The Chinese government wants a devaluation, they just want it on their terms.”

Reuters had previously reported that the Chinese central bank would not mind seeing the currency slip to 6.80 against the dollar, a target it will likely overshoot if things don’t change materially.  

Bass also shines light on why the regime would not be opposed to devaluing the currency, albeit measuredly. He says one of president Xi Jinping’s closest aides, vice premier Wang Yang, thinks the Japanese made a mistake by not devaluing in the mid-1980s, right when they were blowing up their own credit bubble. 

“Wang has said that he thinks Japan’s critical error was agreeing to the Plaza Accord. Japan decided to be submissive to the United States once again, to sacrifice their economic growth for that of the United States,” as the dollar devalued and the Japanese yen strengthened, the United States finally emerged out of a decade of stagflation. what happened to Japan at the beginning of the 1990s was less flattering. According to Bass, however, this time will be different: “They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.”

After the devaluation and the recapitalization of the banking system, however, it’s time to buy again: “If you have any money left, it will be the best time in the world to invest. It will be the greatest time ever to invest in Asia.”

Read the full article here

By now most people have realized that China is, one, addicted to debt and, two, its debt addiction is not sustainable.
Any country investing around 50 percent of GDP in infrastructure and productive assets over a decade or so will run into overcapacity problems. Overcapacity simply means there is infrastructure and factories to make things, but nobody is consuming them.
No, or not enough consumption means no cash flow and if the projects are debt-financed this creates a payment problem.  
It is impossible to avoid deterioration in the efficiency of credit allocation with the pace of debt growth that China has seen. — Wei Yao, Société Générale

China fans—until recently—have brushed this argument aside saying that the country is growing very fast and will one day be able to use this infrastructure. Furthermore, the totalitarian communist regime could always bail out everybody.
There are still some people who believe China will escape its 300-350 percent debt to GDP load and decreasing debt efficiency without much of a crisis.
This optimistic scenario is unlikely to happen according to Société Générale’s chief China economist Wei Yao. She thinks China has to restructure one way or another and presents some more realistic albeit unpleasant outcomes.
(Société Générale)
“It is impossible to avoid deterioration in the efficiency of credit allocation with the pace of debt growth that China has seen. In our view, the reason that China has so far avoided a banking crisis is because it remains a relatively closed system,” writes Yao.
The main problem, according to Yao, are the State Owned Enterprises (SOEs), which have the most debt (127 percent debt to GDP), worst profitability (3.4 percent of GDP), and worst return on assets (smaller than 2 percent). More than a quarter of the industrial SOEs are consistently loss-making.
Total losses in the banking sector could reach $1.2 trillion, equivalent to more than 60 percent of commercial banks’ capital, 50 percent of fiscal revenues and 12 percent of GDP. — Wei Yao, Société Générale

Given their track record, Société Générale estimates about 18 percent of SOE debt could go bad, leading to total losses of around $800 billion. Losses to the Chinese banking system because state banks own most of SOE loans and bonds.
The Communist Party ultimately controls the whole banking system either outright or through the state organs. And it’s CCP officials who benefit most from corruption. “The bankers, whose primary allegiance is to the Party rather than to their institutions, still have little choice but to support local government projects,” Mark DeWeaver wrote in his book “Animal Spirits With Chinese Characteristics.”
(Société Générale)
So Société Générale thinks that”all in all, SOE debt restructuring could jeopardize 50 percent or more of the banks’ capital base, which—if it materializes quickly—would almost certainly knock China’s banking sector into a systemic crisis.”
While these words may sound shocking to the uninitiated, it is nothing we haven’t seen before. China had to bail out SOEs and banks in the late 1990s when 30 to 50 percent of all debt went bad.
In the late 1990s, the government completely bailed out the SOEs and the banks, but this is unlikely to happen again.

So bailing out the SOEs will also involve bailing out the banks as well. Nobody likes bail-outs, but Société Générale has some suggestions how to minimize the damage.
First, the so-called “zombie companies” should be closed down systematically and the debt written off. Given the magnitude of the bad loans, however, the banks cannot shoulder that cost alone, a cost which is going to be higher than just the bad SOE debt.
Because of some knock on effects and some private sector problems, “total losses in the banking sector could reach $1.2 trillion, equivalent to more than 60 percent of commercial banks’ capital, 50 percent of fiscal revenues and 12 percent of GDP.”
Restructuring Options
In the late 1990s, the government completely bailed out the SOEs and the banks, but this is unlikely to happen again.
“Previously, the government—also the sole shareholder of China’s banking sector at the time—picked up the lion’s share of the bill, and it received significant help from solid economic growth in the 2000s. This time, not only will that same split be hard to achieve—and it should not be replicated—but future economic growth will not be as helpful either,” writes Yao.
Aside from forcing banks to exchange bad debt for an equity stake in the troubled company, which is a short-term fix, banks will have to use up their existing capital base and also raise new money from private investors.
The central government would then issue new bonds (currently only 15 percent of debt to GDP are in the form of government bonds) to the tune of 10 percent of GDP.
The bottom line is that the government bail-out program could be designed in a way to greatly limit its impacts on currency and capital account stability. — Wei Yao, Société Générale

“The new [bond] supply would be equivalent to 3-9 percent of GDP, 12-35 percent of fiscal revenues and 20-60 percent of outstanding [bonds]. In addition to bank recapitalization, the government would have to provide fiscal support to address unemployment pain and other social effects. The total fiscal bill would probably be considerably more than 10 percent of GDP.”
The People’s Bank of China (PBOC) could play a role by either doing Quantitative Easing (QE) and buying up some of the bond supply or by using up its foreign exchange reserves to make up for the banking losses. It would have to because the Chinese bond market is not liquid enough to just double in size within the space of a year or so. 
Both options are not without problems, however, as QE would put further pressure on the already brittle currency whereas the selling of foreign exchange reserves would put deflationary pressure on the already deflating manufacturing economy.  
In the best case scenario, those two factors could offset each other.
“The bottom line is that the government bail-out program could be designed in a way to greatly limit its impacts on currency and capital account stability. Such designs seem

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After the market fireworks at the beginning of the year, things started to quiet down at the end of February right after the G20 meeting in China. This quiet is about to end if we take the Chinese currency as an indicator.
Markets were worried the yuan would crash against the dollar with some hedge fund managers even betting on a 50 percent decline in 2016. China’s stock market crashed some 25 percent in January and the S&P 500 lost almost 10 percent at its low point in February.
After the unofficial Shanghai Accords—named after the place of the G20 meeting—this concern receded as the U.S. dollar weakened and emerging market currencies including China’s yuan appreciated. The Federal Reserve played a part as it skipped raising interest rates during its first meetings in 2016 and Chinese capital outflows markedly slowed from March onwards.
So the yuan hit a relative high against the dollar in March at 6.45, the S&P 500 made it to green for the year, but it seems this was as good as it gets.
For no apparent reason, the yuan then started to decline and is approaching the January lows of 6.60 per dollar.

At the beginning of May, Australia defected from the rest of the world’s central banks by cutting interest rates in an effort to weaken its currency, breaching the agreement to let the dollar weaken across the board.
On May 18, the Federal Reserve released the minutes of its March meeting, indicating it may just raise rates again. This led to a sharp sell-off in the Chinese currency and prompted the People’s Bank of China (PBOC) to intervene in the currency markets to strengthen the yuan.
The Chinese economy and possible capital outflows are coming to the forefront of analysts and traders again.
Read MoreChina Expert Evan Lorenz Says Yuan Devaluation Will Happen
“China’s macro [economic picture] may weaken (against the recent consensus of a cyclical upturn) and there is a risk that capital outflows will pick up again,” the investment bank Nomura writes in a note to clients.
Ever since the Fed started to tighten global liquidity at the end of 2013, the U.S. dollar has steadily crept higher, conversely pulling the yuan lower. Since 2015, the falling Chinese currency has preceded market turmoil in the fall of last year and at the beginning of this year.  
Now all eyes are on the Fed which meets on June 16-17 and is highly likely to raise rates, at least according to best-selling author James Rickards:
“I think in June, particularly after having skipped March, they’re going to want to get back on track. They’re going to raise rates, but the market expectation is still not better than 50 percent that they will,” he said right when the dollar put in a bottom in March.  

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Another book written in 2012 that too few people paid attention to. If they had, they could have easily predicted and avoided the current troubles in China. From the inevitable overinvestment, to environmental destruction, to the futility of monetary policy and the chronic lack of innovation, Mark DeWeaver covers it all—in history, in theory, and in modern-day (mal)practice.
The biggest myth he dispels about the Chinese economy is that it’s socialist in name only and run by private enterprises big and small alike.
“Perverse incentives at the local government level continue to be the underlying drivers. Neither extinct nor even endangered, the animal spirits of the Maoist era are still thriving more than thirty years after the introduction of China’s ‘reform and opening’ policy in 1978.”
When ‘numbers produce officials and officials produce numbers,’ as the Chinese say, outright fraud will be an issue as well.— Mark A. DeWeaver

Local Distortion
The local governments in very ordinary terms do whatever they want until Beijing throws the baby out with the bathtub and restricts all investment activity everywhere.
“Booms are led neither by Beijing nor by the private sector, but by local government officials motivated by interests all their own,” DeWeaver writes.
So what are the local government’s, or the local government official’s, interests? No, it’s not like it says in the CCP’s constitution, that a party member should always put the party ahead of personal interests.
In fact, it’s these very personal interests that drove overinvestment in industrial capacity and real estate. The CCP rewards local officials through a tournament system where they compete against other local officials to get the best numbers, be it GDP or otherwise, with devastating results for capital allocation and the natural environment.
“When ‘numbers produce officials and officials produce numbers,’ as the Chinese say, outright fraud will be an issue as well.”
Mark A. DeWeaver
A good example is China’s goal to have non-hydro alternative energy cover 8 percent of installed capacity by 2020. Because the emphasis is on capacity and investment expenditure, 26 percent of China’s wind-power capacity was not connected to the power grid at the end 2010. Many of the wind farms are continuously blasted by sand from the desert, leading to mechanical failures and defects.
This is also the reason why every province and second-tier city in China needs its own airport, regardless of economic viability. “Some ‘image projects’ have no discernible rationale at all aside from creating the impression that officials are getting things done.”
Investment in infrastructure and real-estate generates GDP growth, the stick local officials measure each other against. They use tax breaks, cheap land, low-cost credit (channeled via locally-controlled banks) as well as waivers on centrally imposed labor and environmental regulations to attract private and public sector investment.
The PBOC has many of the same tools as the developed country central banks, but it uses them differently and they generally are less effective as instruments of countercyclical policy.— Mark A. DeWeaver

Because was is no downside for the local officials, at least not until Xi Jinping unleashed his anti-corruption campaign in 2013, capital was misallocated, the natural environment destroyed, and arable farmland converted into unused real estate.
Of course, there is plenty of upside in terms of corruption for the average local official. “Bid rigging is exceptionally easy to get away with because the same officials are often in charge both of inviting bids, in their capacity of transportation department employees, and submitting bids, in their capacity as managers of department-owned construction companies.”
No Central Control
DeWeaver then shows that the much-touted central government control and foresight only has very crude mechanisms to reign in wasteful local government spending.
First of all, most banks, whether central or local are ultimately controlled by the CCP. And it’s CCP officials who benefit most from corruption. “The bankers, whose primary allegiance is to the Party rather than to their institutions, still have little choice but to support local government projects.”
As for the central bank’s ability to manage credit, DeWeaver was way ahead of the curve in noting that the impossible trinity renders the efforts of the People’s Bank of China [PBOC] to control bank lending futile, and describes the process in great detail.
“The PBOC has many of the same tools as the developed country central banks, but it uses them differently and they generally are less effective as instruments of countercyclical policy.”
Innovation: We’ve Been Here Before
The icing on the cake of this book, however, is how DeWeaver deals with the claim that China will one day become a leading source of innovation, a narrative much espoused by consulting firm McKinsey for example.
Proponents of the China innovation story often cite the amount of money spent on research and development as well as the number of patents filed. But, like everything in China, and much like the local government GDP growth targets, these figures are given by the regime.
So the national “Medium- And Long-Term Plan for the Development of Science and Technology” targets R&D expenditure of 2.5 percent of GDP by 2020. Lo and behold, China spent 2 percent of GDP on R&D in 2013 producing little, if any, countable results. The same target goes for patent filings, where China is supposed to be number five globally in 2020. In 2014, it was number one already, without anybody in the world noticing.
“This way of thinking substitutes quantity for quality, just as [with] the targets for steel tonnage during the Great Leap Forward,” writes Weaver.
So it comes as a small surprise that more than half of China’s science and technology R&D funding is wasted on non-research activities like business trips, meetings, and entertainment, according to a recent report by
DeWeaver also notes that this push for innovation is not a new idea. In fact, the sixth five-year plan of 1982 has much the same content than the 11th and 12th five-year plan, other than the specific mention of scientific development.
Much like the Soviets in the 1980s, DeWeaver notes that you can plan to innovate as much as you like; as long as you get the incentives wrong, all you are going to get

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Until now, most of the action has been taking place overseas, far away from American shores. But in an interconnected global economy and financial system, the China crisis is already impacting the United States and will soon impact you too—both positively and negatively.
Financial markets reacted first. China’s stock market is down 22 percent this year. Japan is down 14, Germany 16 percent, all of them extending their slump from 2015.
Relatively speaking, the United States is doing well—the S&P 500 is only down 9.3 percent. But even America won’t be able to save itself from the contagion of a Chinese economy on the edge of the abyss.
Growth in China has slowed to a number much lower than the official 6.9 percent. Capital is leaving the country by the hundreds of billions of dollars every month, the stock market is crashing, and the currency depreciating.
The Ghost of 1997
“There are worries about a rerun of [the 1997 Asian financial crisis] of a series of competitive devaluations,” says Sherle Schwenninger, director of the World Economic Roundtable at the think tank New America Foundation.
Whether competitive or not, almost all emerging market currencies from the South African Rand to the Turkish Lira and the Chinese renminbi are falling against the dollar, exacerbating a problem which started in China in late 2014.
Schwenninger says if emerging market currencies fall in value, dollar debt increases in value, which makes it harder for companies and countries to pay it back. And it’s not just China that has lots of it, $870 billion according to the Bank of International Settlements.   
Those two factors together, China and commodities, are both stimulative for the world economy and a central part of the adjustment to get away from the post crisis distortion.— Charles Dumas, Lombard Street Research

“The larger amount of corporate dollar debt is held by Asian economies and the Western exposure ripples through London Hong Kong and European banks. … The Hong Kong banks are heavily exposed to China’s state owned enterprises,” says Schwenninger.
“Deutsche Bank is a perfect example. They are knee deep in all that stuff,” says Jeffrey Snider, chief investment officer of Alhambra Investment Partners. Deutsche Bank shares are down 39 percent this year, a little more than the shares of Swiss bank Credit Suisse (-35 percent), which Snider says invested too much in its Fixed Income, Currencies and Commodities (FICC) division, or everything that is suffering right now. As a comparison, U.S. bellwether JPMorgan Chase & Co. is only down 13 percent.   
But the banks aren’t just exposed to corporate debt from Asia. The China slowdown has wreaked havoc among energy and commodity traders and producers alike.
Commodity Carnage
“There are systemic linkages to the international financial system. Major commodity firms may end up defaulting in 2016. This is coming to play out in the coming months as more and more cracks are appearing in the commodity complex,” says John Butler, head of wealth services at Gold Money.

Energy and commodity producers world-wide were counting on China to keep on growing 7 percent every year indefinitely and invested hundreds of billions to expand supply.
Once demand for commodities started slowing in China, prices for copper (down from $4.5 to $2.12 per pound since Jan. 2011) and iron ore (down from $180 per ton to $38 per ton since 2011) crashed. China is not alone responsible for the decline in the oil prices (West Texas Intermediate is down to $31 from a little over $100 in 2011) but this trend is also hurting producers and the banks who underwrote the loans to energy companies.
“People were holding oil and copper and other things not because of good fundamentals but because they thought the returns there would be greater than in Treasurys and German government bonds. A lot of that money has come out of the market. Hedge funds have been delevering and liquidating their positions in the China growth story. You had the rush of money out, which creates a contagion effect,” says Schwenninger.
I think the idea is that you feel so smart and so wealthy because of appreciating asset prices that you are led to consume more. I think the empirical evidence for this wealth effect is very, very slight.— James Grant, Grant’s Interest Rate Observer

“There is a lot of bad collateral out there, there is a lot of junk debt that has been overvalued and it is going have to be written down,” says Butler.
Shares in British commodity trading companies like Glencore PLC is down 62 percent over the last year. The mining company Anglo American PLC is down 68 percent and announced it would fire tens of thousands of its work force.  
Multinational Impact
Even if U.S. banks for once are not exposed to the epicenter of the crisis, the fact that three large sectors of global multinationals (banks, commodities, and energy) are on the defensive means it has an impact on the earnings of U.S. multinationals as well.
“American multinationals who depend on global markets are going to be hurt competitively, and we have seen that show up,” says Schwenninger. Apple Inc. is down 11 percent in 2016, partly due to a bad earnings report, which blamed China for weak iPhone sales.
Apple’s share price year-to-date (Google Finance)
“We are coming off four or five quarters of negative earnings growth,” says Snider, who also believes the market has lost faith in central banks to fight off a global crisis. “It’s the idea of transitory. It’s all short term, don’t worry about it,” he says has been the mantra of global central banks the market has believed in so far, but not anymore. “The fact it has dragged on over a year, the idea of transitory and temporary weakness is no longer plausible.”
So how does this affect you? Unless you own a lot of stocks in general or the weak sectors in particular or you work for a shale gas producer, the whole China slow-down could actually have a positive effect on the consumer.
We are coming off four or five quarters of negative earnings growth.— Jeffrey Snider, Alhambra Investment Partners

It’s the exact opposite of

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January 26, 2016

The falling yuan and slowing economy must be wearing on the Chinese regime. Otherwise, why would they publish a childish Op-ed on the People’s Daily front page attacking billionaire investor George Soros titled “Declaring War on China’s Currency? Ha Ha.”
First of all, nobody knows whether Soros is really declaring war on the yuan. He only said he was short Asian currencies and China would have a hard landing at an interview at the World Economic Forum in Davos last week.
Maybe it was this statement that rubbed the Communist Party mouthpiece the wrong way, as they also defended the Chinese economy at large after making this statement about the currency: “Soros’s challenge for the renminbi and the Hong Kong dollar is unlikely to succeed—there is no doubt.”
Aside from the fact that there is doubt if it is just unlikely and not impossible, Soros never said he was targeting the renminbi and the Hong Kong dollar and even granted China the ability to manage a hard landing.

This did not prevent the People’s Daily from blaming him for the steady decline of the yuan. “Because of his influence, fluctuations in the international financial markets has intensified already existing speculative attacks. Asian currencies obviously feel greater pressure.”
So if we assume Soros is indeed short the onshore or offshore yuan or the Hong Kong dollar, who would be right, the People’s Daily or him?
Maybe the Chinese regime thought it had to nip Soros’s influence in the butt because he is usually right about when currencies have to devalue, especially when they are pegged to other currencies.
Soros’s challenge for the renminbi and the Hong Kong dollar is unlikely to succeed—there is no doubt.

For starters, he made 1 billion pounds betting against the bank of England on September 16, 1992, when Britain had to withdraw the pound sterling from the rigid European Exchange Rate Mechanism (ERM). Estimates vary, but the Bank of England spent 2 billion an hour in the morning of that day to defend the currency against Soros. Incidentally, this number is close to the $3.5 billion China spent every day in December to defend its exchange rate. At least the Brits gave up in the afternoon. China is still fighting on.  
Several officials and politicians have also accused Soros of participating in the demise of the Asian currencies during the Asian financial crisis in 1997, although it is unclear to what degree and how much money he made.
The People’s Daily doesn’t think this matters much though and we should look at the larger historical context: “The continued appreciation of one currency against the US dollar for such a long time, and with an amplitude so large is rare. A slight pullback now is normal.”
Of course, it helps if the currency devalues 33 percent before in starts to appreciate, like in 1994, which took the rate from 4.7 yuan per dollar to 8.7 but this is beside the point. The point is Soros sees the same problems he saw in Europe in the early 90s and in Asia in the late 90s.
(Raymond James)
The first commonality is a dominant central bank tightening monetary policy. This was the Bundesbank in 1992 and the Federal Reserve in 1997, although both started their cycle much earlier. In this decade, the Fed started tightening monetary policy in 2013 with the beginning of the end of quantitative easing. The recent 0.25 percent rate hike is just the continuation of that policy. Relatively tighter monetary policy made the Deutsche Mark more attractive versus the pound and the dollar more attractive compared to the Asian currencies in 1997 and now.
The other commonality is a combination of debt and deteriorating assets. Although China has paid down a large portion of its foreign debt, there is still $877 left. This is the unwind of the carry trade which was the biggest factor in the Asia currency crisis of 1997 and plays a relatively smaller part for China in 2016.
China shares the fate of the United Kingdom in 1992 that domestic and international investors are losing confidence in the economy and asset markets. Even though the UK raised interest rates from 10 to 15 percent in one day, it did not convince markets it would sustain that level given a faltering economy.    
China is far away from raising rates and in fact is trying to ease domestic liquidity conditions because of an unprecedented economic slowdown. In addition, much like Germany’s government bonds were preferred to the UK’s in 1992 because of a stronger economy and lower inflation, the United States’ stocks, bonds, and real estate are preferred to Chinese real estate, stocks, and bank deposits because of deflation and systemic risks in the banking system.
Of course, don’t tell this to the People’s Daily. It hopes speculative attacks, which just profit from fundamental economic problems and never cause them, will lead to more financial cooperation between the Asian nations and even a single currency.
“International monetary cooperation from low to high is divided into international financing cooperation, joint intervention in currency markets, macroeconomic policy coordination, joint exchange rate mechanism, and a single currency. The direct power of its deepening is usually pressure from speculative currency attacks,” it states.
Of course, the editors missed the point that Germany did not intervene on the UK’s behalf in 1992 and founded the euro single currency with the countries who were still part of the ERM—after won the war against the pound.    

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In the new normal of investing central banks run the economy. If growth slows down, the central bank will fix it. If the currency is too high, the central bank will fix it.
Especially the Chinese central bank (PBOC) was very adept at managing small or large glitches in China’s planned economy, at least until recently and without worrying about the long-term effect. In 2016, however, managing the economy and the exchange rate became too tall of an order.
So the PBOC leaked documents to the press saying it can’t do everything at the same time, like keep the yuan from falling and stimulate the domestic economy.
The South China Morning Post cites a leaked memo where assistant central bank governor Zhang Xiaohui told commercial banks that “a too-loose liquidity situation may result in relatively big pressure on the yuan exchange rate.”
He also said the PBOC won’t use the markets preferred measure of stimulus, a cut in the required reserve ratio, which gives banks more room to lend and expand credit in the economy.
“A cut in the required reserve ratio would be too strong a signal [to send to the market], and we can use other tools to provide the market with liquidity,” he said.
The PBOC finally realized that it too is subject to the law of the impossible trinity, which says you can only have two out of the three following treats: An independent monetary policy, a stable currency, and an open capital account.
So according to the leaked memo, later confirmed by the official minutes, the PBOC choses to have a stable currency and consequently must import the Federal Reserve’s tight monetary policy.
Blurred Lines
But the options here are not black and white given China’s recent push for reform.
First of all, China’s capital account in neither completely open nor completely closed. While there are many restrictions, like the maximum $50,000 an individual can transfer out of the country every year, those limitations are violated on a daily basis and to a larger degree by multinational firms and wealthy individuals with political connections.
Capital outflows lead to a declining exchange rate (Macquarie)
At the same time, China is not keeping a strict peg to the dollar anymore, like it did until 2005 and it is still the case in Hong Kong. The reform goal is to have a freely convertible currency by 2020.
China is rather managing a gradual decline in the rate. If China is serious about having a floating exchange rate by the end of the decade, it will have to open the capital account even further.
Once the capital account is open and the exchange rate floated, the PBOC can then manipulate domestic foreign policy as it pleases.  
But even if the PBOC choses to emphasize a stable exchange rate for the time being and the capital account is semi-closed, it still has different tools for domestic foreign policy as well, like not using the required reserve ratio and instead use open market operations. Only last week, it injected around $250 billion dollars into the banking system with this method, a method that also has a negative effect on the exchange rate, although the PBOC hopes a it is a less pronounced one. 
But no matter which of the blurred options the PBOC choses, it can only manage expectations in the short term. It won’t be able to solve the fundamental problems of the Chinese economy which require serious reform—a fate it shares with all other central banks.

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After a pretty rough ride in the summer, China is staging a comeback in the fall. 
Just as the International Monetary Fund is about to decide whether to include China in the world’s reserve currency basket, the stock market is rallying, up 15 percent over the past months.
Large swings in China’s stock market are pretty common, but there is another indicator that has turned around: foreign exchange reserves.
They rose by $11.4 billion in October. The market expected outflows in the range of $50 billion, similar to the drain plaguing China for over a year.
The depletion of China’s massive pile of reserves ($4 trillion at the peak in 2014) means capital if leaving the country, and has been for a while. Now the sudden and unexpected change. 
Does this mean the trend of capital flight has reversed for good? Most likely the answer is no for several reasons. 
First of all, nobody really knows what’s included in China’s $3.5 trillion piggy bank. If the market value of the portfolio appreciates by only 1 percent for example, FX reserves rise by $35 billion without anybody moving a finger.
Goldman Sachs says: “Besides currency movements, there could also be significant valuation effects from changes to the market prices of the People’s Bank of China’s investment portfolios, and those effects are hard to estimate given the uncertain asset composition.”
In addition, China is hiding outflows with derivative transactions through state-owned banks, which may only register at a later date. 
For example: Factoring in banks’ derivative positions, China’s foreign exchange reserves dropped by $110 billion in September compared to official figures of $43 billion, according to Goldman.
Nomura found movements in the currency markets support the argument China was still intervening to support the yuan in October.
“Intervention was especially heavy on Oct. 30 when both onshore and offshore yuan gained substantially against the dollar. Daily volume transacted was also larger than normal on Oct. 30.
Price movement of the U.S. dollar compared tot eh Chinese yuan on in October. (Nomura)
Also, foreign exchange reserves are just one element of the total movement of capital. Foreign money is still moving into China through trade (roughly $61.6 billion in October) and other channels, but the largest portion of it flows straight out again.  
MORE:As Much as $850 Billion Left China So Far This Year
So despite the small break in October, Nomura believes outflows will continue in the medium term: “We see some risk of increased capital outflows from locals as well as increased investment outflows especially as China’s capital account liberalization continues.”

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Yuan banknotes and US dollars are seen on a table in Yichang, central China's Hubei province on Aug. 14. China's central bank raised the value of the yuan against the US dollar by 0.05 percent after three days of devaluation. (STR/AFP/Getty Images)Yuan banknotes and US dollars are seen on a table in Yichang, central China's Hubei province on Aug. 14. China's central bank raised the value of the yuan against the US dollar by 0.05 percent after three days of devaluation. (STR/AFP/Getty Images)

Yesterday we got another confirmation that China is selling more foreign exchange reserves to keep its currency stable.

But what does this actually mean? Sure, the $43 billion number the People’s Bank of China released yesterday is quoted in dollars.

That doesn’t mean, however, that China only sold dollar reserves, such as Treasury bonds. It could sell euros, yen, pounds, stocks, bonds, gold: everything is possible because we don’t know how China is investing its reserves.

Goldman Sachs estimates China is keeping roughly 70 percent of its $3.5 trillion reserves in U.S. dollars, or $2.45 trillion.

Of these, we know that China itself was holding $1.24 trillion in Treasury securities in July of 2015 (watch out for the August number coming out mid-October), down from $1.32 trillion in November of 2013.

This $80 billion decline, however, doesn’t match the $400 billion decline in foreign exchange reserves from August of last year. Instead we need to look to another country and go back in time a little to find out China has indeed been selling mostly Treasury securities.

As official Chinese holdings topped out in November of 2013, all of a sudden and without official notice, Belgian holdings—historically around $150 billion—started to soar. The country accumulated $213 billion worth of Treasurys from Sept. 2013 to March 2014 ($381 billion).

In order to accumulate such a large amount of Treasurys one needs a large trade surplus. Belgium’s modest surplus of $30 billion for the few months in question at the turn of the year in 2013 doesn’t fit the bill.

China, however, did have a trade surplus sufficiently large to be able to buy this amount of Treasurys, the question is why it would do so through Belgium.

Belgium operates the Euroclear system which let’s foreign countries transact anonymously and China has had a history of using UK accounts to buy Treasurys. Using different fronts makes sense to not show your hand to the markets, especially if you are buying in size.  

It’s also good if you are selling in size, which started to happen in Belgium in earnest in February of 2015. Holdings dropped $93 billion in a single month, right when the capital outflows of China started to shift into high gear.

Taken together, China and Belgium have sold $185 billion worth of Treasurys until July 2015, or 92.5 percent of all foreign exchange holdings sold until that month, even more than the 70 percent Goldman estimated. This is likely because China is strapped for dollars (not euros or yen) and needed to offload quickly—for that the Treasury market guarantees the best results.  

Now that the Belgian buffer is depleted however, all eyes are on Chinese holding when the Treasury next releases the major foreign holders data in October.

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