China, once a cuddly panda, is now a violent dragon. The tide has turned, and financial transactions that were previously tolerated are now banned.
2017 has barely begun, and yet China has enacted a flurry of financial regulations to stem the outflow of CNY, and in its wake, arrest a whole-scale financial meltdown. USDCNY flirts with 7.00. Once that level falls, the light of financial truth will shine on China’s cockroach-infested capital account.
In a previous newsletter, I estimated that on January 1st, another $800 billion could legally leave China due to the $50,000 FX limit quota per adult. The State Administration of Foreign Exchange (SAFE) chose to begin enforcing current regulations which prohibit the use of the FX quota for investment purposes.
Comrades must now declare to their bank how their quota will be used. Overseas tuition payments, family visits, and medical treatment are permitted. Buying Hong Kong issued insurance policies, fancy flats in Vancouver and Sydney, however are forbidden. Should a comrade violate the will of Beijing and be caught, they forfeit their quota for up to 3 years. [Bloomberg]
Governments globally love to create endless pages of laws and regulations so they may cherry pick enforcement. Harvey Silvergate estimates that Americans commit three felonies per day. [WSJ] Committing a felony in America disenfranchises you for life. China is no different. The “law” is what the Party says it is, and it is almost impossible to predict what the “law” will be on any given day.
The Hong Kong Dollar Peg Will Fall
China’s woes don’t end with citizens converting CNY into USD legally. The CNH (offshore Yuan) plunge protection team is in full force. To deter evil speculators from shorting CNH, the PBOC has driven up the cost of borrowing CNH in Hong Kong to nosebleed levels. The CNH funding crunch will affect USD and HKD interbank lending rates for Hong Kong and Mainland banks.
The first tremors are being felt in the Hong Kong Interbank Offered Rate (HIBOR). HIBOR is at levels not seen since the 2008 GFC. [Analystz.HK] For year, wealthy Chinese have plowed into the Hong Kong property market. With Fed Funds at 0% to 0.25% for almost a decade, it was almost free to own Hong Kong property. The HKD is pegged to the USD, therefore Hong Kong imports American monetary policy.
Chinese investors purchased a USD asset, with leverage, with a very low interest expense. All they had to do was take a bus, ferry, car, or plane across the border to Hong Kong. No questions would be asked about the provenance of the cash used for the down payment.
If Hong Kong property prices begin to fall due to investors’ inability to fund their investment, it will be a stampede for the exit. But who will be left to buy? Beijing on multiple occasions has asserted its de facto control over Hong Kong. Booksellers have been apprehended, duly elected members of the legislative body denied entry, and the hope of universal suffrage in 2017 annihilated.
The city is gearing up for the 2017 Chief Executive (CE) election. Those who stand for CE must be approved by Beijing, and they are elected by LEGCO representatives. LEGCO is made up of unelected representatives from various business constituencies, and a smattering of popularly elected representatives.
The 2014 Umbrella Revolution in Hong Kong began when Beijing effectively said No to allowing the 2017 CE to be elected via universal suffrage. This violated their agreement with Britain during the 1997 Handover. Students took to the streets in protest. The protest eventually ended, but everyone knew the real battle would be this year during the CE “election”.
Beijing will unequivocally demonstrate that China owns Hong Kong. The implications for capital are severe. If Beijing controls Hong Kong, then the capital of those who believed they escaped the purview of Chinese financial regulators is fair game. Legally, there is no way to have squirreled enough money out of China to purchase a Hong Kong property. My childhood bedroom would be a multi-million dollar apartment were it situated in Hong Kong.
He who sells first, sells best. The Chinese will dump Hong Kong assets (i.e. property). The question is what to do with the HKD they have received. The first step is to convert HKD into USD. It is believed that the HKD is backed 1:1 with USD at the Hong Kong Monetary Authority (HKMA). We will find out the truth in that. If the HKMA has been cheating, the peg could fall under intense selling of HKD for USD.
The HKMA decreed the HKD can trade between 7.75 to 7.85 vs. the USD. My outrageous prediction for 2017 is that the HKD peg falls, and it trades materially weaker. A rush for the exits by Chinese asset holders will precipitate the fall of the peg. Then Beijing will make the political decision to weaken HKD aggressively to match where CNY is trading.
Beware of Chinese New Year
Last year, I falsely predicted that the PBOC would aggressively devalue CNY over the lunar new year. At the beginning of 2016, China’s “official” FX reserves stood near $4 trillion. This year, they stand at $3 trillion. The pace of outflows accelerated in 2016, and the pace of new financial regulations aimed at closing gaping capital account loopholes also intensified.
China must act swiftly before too much Yuan escapes. Another year of loophole whack-a-mole cannot happen. It is do or die time for Beijing if they want to avert a financial meltdown. Trapping CNY in the country to help fund a roll-over of the vast amount of corporate and local government debt is essential.
Over the next twelve months, savers will find holes in the enforcement of the FX quota regulations. Most likely they will bribe national banks’ local office managers to allow them to skirt the rules. China is huge, and Beijing’s control nationally is always touch and go.
Banks are closed from January 27th to February 2nd. A large one-off devaluation to USDCNY 9.00 would solve the problem. During the 1990s China faced a similar problem. Credit was overextended and 40% of Chinese banks’ loan books were non-performing (NPL). [The Diplomat] Analysts believe similar NPL ratios for Chinese banks exist today. A 30% devaluation would provide suitable breathing room for the PBOC to print enough CNY to paper over the problem.
The best case for China is to become the 21st century Japan. Japan avoided an outright financial collapse for almost 30 years by financially repressing savers with low interest rates. For China, this road starts with an aggressive devaluation.
Bitcoin, The Small Door
During times of financial panic, many alternative assets gain value. Bitcoin’s market cap is only $16 billion. Only a small portion of CNY will be able to find a home in Bitcoin. Even if the price grew 10x from current levels, Bitcoin would still not be able to absorb the sheer volume of CNY looking for a safe haven.
As Bitcoin nears all-time-high’s in CNY terms, desperate savers will investigate just what Bitcoin is. Many 2013 bubble bag holders will rekindle their love of Bitcoin and other digital assets.
Chinese savers aren’t stupid. The events around the globe have proven that central bankers will lie and lie, until the moment of truth arrives. Overnight Chinese households will see their wealth greatly diminished. The race is on to find a door out of China.
Those who previously found refuge in Hong Kong will need a new place to store their USD. It will flow into gold, shares of western blue-chip companies, and alternative assets like Bitcoin.