Every Chinese comrade can legally convert $50,000 worth of Yuan into a foreign currency each year. That quota resets on January 1st.
Year to date, the Yuan has weakened 6.33% against the USD. China’s FX reserves have “officially” tumbled to $3.052 trillion, the lowest in six years.
China’s FX reserves are a representation of the gift that exporters were granted at the expense of households. The PBOC could sell USD and purchase CNY, strengthening the Yuan. That would provide households with better purchasing power for imported goods. However, this would hobble the politically powerful export lobby, and diminish the riches of many government officials.
Due to the enormous amount of credit created with fewer and productive uses for it, the PBOC must export deflation abroad by weakening the Yuan. Many emerging countries have faced similar problems, and the weakening episode was volatile and chaotic. The FX reserves are the PBOC’s volatility smoothing tool. Until recently, China had capital controls imposed on the poor, but left the door wide open for the elites to cut loose. Rich Chinese were allowed to leave China, and levitate global property markets to unseen levels.
The elites recognise that the priorities of the Party have changed. To maintain a harmonious society, Beijing must favour poor and middle-class households over industrial barons. That means the doors are shut for capital leaving China, which is also the cause of Xi Jinping’s anti-corruption campaign.
If capital flees too quickly, the PBOC will not be able to devalue the Yuan in an orderly fashion. I have detailed in various past newsletters the popular capital fight avenues that are now closed. But the biggest risk now isn’t large chunky transactions, but instead a flurry of small legal ones.
A Thought Experiment
According to the CIA World Factbook, China has 1.084 billion people over the age of 18. If just 61 million people (5.63% of those eligible) converted $50,000 of CNY into USD, then that would exhaust the FX reserves.
According to Household Wealth in China (Yu Xie and Yongai Jin), the top 10% of Chinese households hold CNY692,000 of assets ($100,000 equivalent). Housing assets account for 70% of wealth, so let’s assume a household consists of two adults and have $30,000 equivalent of cash that could be converted. This means that 54.19 million households could theoretically convert their $30,000 of liquid assets.
Prior to August 2015, the CNY was strengthening, however the mood has changed and most Chinese want to move their depreciating cash out. Assume that in 2016 each household converted $15,000 of CNY into USD, and then will convert another $15,000 in 2017. On 1st January 2017, the FX reserves then could fall by another $813 billion legally.
Due to prior economic commitments such as China’s One Belt, One Road project, and Asian Development Bank contribution, if the FX reserves fall below $2 trillion they are basically broke.
A drawdown of $813 billion would bring the official tally to $2.239 trillion. That is very close to the red line.
The PBOC’s Options
As much as the PBOC would like to reduce the quota to zero, that action would signal something is dangerously amiss with China’s capital account.
A reduction of the quota, would signal it’s do or die time to convert CNY into a real asset or strong currency. China is a large place, Beijing’s control fades quickly as you move outward. Beijing will not be able to efficiently stop the flood of money leaving the country through more nefarious means.
Instead, the PBOC will make the conversion process very difficult. Banks will be instructed to invent convoluted tasks and superfluous forms that customers must complete. Failure to dot all the I’s and cross all the T’s, will result in “Cannot”. If you have lived in Asia long enough, you know it is futile to debate a customer service representative once they utter “Cannot”. You must go back to square one, and correctly complete the stated process, however ridiculous and illogical it may be.
While comrades are busy filling out forms and standing in lines, the PBOC will take a machete through the Yuan like a young Thai coconut. They must move fast before too much money leaves via legal means.
PBOC is Fed Up
The pace at which the Fed governors forecast rates to rise in 2017 surprised markets. According to the Dot Plot, Fed governors forecast three 0.25% hikes next year.
While the markets initially rejoiced at rate normalisation, too much of a good thing is not wanted. It seems traders finally believe in discount rates again. Convexity quickly consumes profits when you move from zero to highly positive interest rates.
Grandma Yellen’s expressed concern regarding a substantial increase in fiscal spending. She cautioned that because the US is at “full” employment, fiscal spending at this point in the business cycle could be highly inflationary. Add a spike in oil prices, and you have the recipe for aggressive rate normalisation. That is deadly for the PBOC.
“From The Side Mate”
Starting January 1st, the vice constricting the PBOC tightens. Comrades will rush to the bank to legally convert their shekels, and a surging USD will increase the speed at which the CNY must weaken.
Until now the markets have shrugged off a weakened Yuan while they fêted Trump. The honeymoon is over. Expect global market volatility to ingest Yuan weakness, and output violent gyrations. Bitcoin will benefit from a weaker Yuan and greater global instability.
Santa granted my two Christmas wishes. All hail Bitcoin $1,000.