On Friday, alongside China's announcement that it had bought over 600 tons of gold in "one month", the PBOC released another
very important data point: its total foreign exchange reserves, which declined by $17.3 billion to $3,694 billion.
We
then put China's change in FX reserves alongside the total Treasury
holdings of China and its "anonymous" offshore Treasury dealer Euroclear
(aka "Belgium") as released by TIC, and found that the dramatic
relationship which
we first discovered back in May,
has persisted - namely virtually the entire delta in Chinese FX
reserves come via China's US Treasury holdings. As in they are being
aggressively sold, to the tune of $107 billion in Treasury sales so far
in 2015.
Then,
to our relief, first JPM noticed. This is what Nikolaos Panigirtzoglou,
author of Flows and Liquidity had to say on the topic of China's
dramatic reserve liquidation
Looking
at China more specifically, it appears that, after adjusting for
currency changes, Chinese FX reserves were depleted for a fourth
straight quarter by around $50bn in Q2. The cumulative reserve depletion between Q3 2014 and Q2 2015 is $160bn after adjusting for currency changes. At
the same time, a current account surplus in Q2 combined with a drawdown
in reserves suggests that capital outflows from China continued for the
fifth straight quarter. Assuming a current account surplus in Q2 of
around $92bn, i.e. $16bn higher than in Q1 due to higher merchandise
trade surplus, we estimate that around $142bn of capital left China in Q2, similar to the previous quarter.
JPM conclusion is actually quite stunning:
This brings the cumulative capital outflow over the past five quarters to $520bn.
Again, we approximate capital flow from the change in FX reserves minus
the current account balance for each previous quarter to arrive at this
estimate (Figure 2).
Incidentally, $520 billion is roughly triple what implied Treasury sales would suggest as China's capital outflow, meaning that China is also liquidating some other USD-denominated
asset(s) at a feverish pace. So far we do not know which, but the chart
above and the magnitude of the Chinese capital outflow is certainly the
biggest story surrounding the world's most populous nation: what is
happening in its stock market is just a diversion.
At
this point JPM goes into a tangent explaining what the practical
implications of a massive capital outflow from China are for the global
economy. Regular readers, especially those who have read our
previous piece on the collapse in the Petrodollar,
the plunge in EM capital inflows, and their impact on capital markets
and global economies can skip this part. Those for whom the interplay of
capital flows and the global economy are new, are urged to read the
following:
One way that slower EM capital flows and credit creation affect the rest of the world is via trade and trade finance.
Trade finance datasets are unfortunately not homogeneous and different
measures capture different aspects of trade finance activity. Reuters
data on trade finance only aggregates loan syndication deals, which have
mandated lead arrangers and thus capture the trends in the large-scale
trade lending business, rather than providing an all-inclusive loans
database. Perhaps the largest source of regularly collected and
methodologically consistent data on trade finance is credit insurers
(see “Testing the Trade Credit and Trade Link: Evidence from Data on
Export Credit Insurance”, Auboin and Engemann, 2013). The Berne Union,
the international trade association for credit and investment insurers
with 79 members, includes the world’s largest private credit insurers
and public export credit agencies. The volume of trade credit insured by
members of the Berne Union covered more than 10% of international trade
in 2012. The Berne Union provides data on insured trade credit, for
both short-term (ST) and medium- and long-term transactions (MLT).
Short-term trade credit insurance accounts for the vast majority at
around 90% of new business in line with IMF estimates that the vast
majority 80%-90% of trade credit is short term.
Figure
4 shows both the Reuters (quarterly) and the Berne Union (annual) data
on trade finance loan syndication and trade credit insurance volumes,
respectively. The quarterly Reuters data showed a clear deceleration this year from the very high levels seen at the end of last year. Looking at the first two quarters of the year, Reuters volumes were down by 25% vs. the 2014 average (Figure 4). The
more comprehensive Berne Union annual volumes are only available
annually and the last observation is for 2014. These data showed a very
benign trade finance picture up until the end of 2014. Trade finance
volumes had been trending up since 2010 at an annual pace of 8.8% per
annum (between 2010 and 2014) which is faster than global nominal GDP
growth of 6% per annum, i.e. the trend in trade finance had been rather
healthy up until 2014, but there are indications of material
slowing this year. This is also reflected in world trade volumes which
have also decelerated this year vs. strong growth in previous years
(Figure 5).
Summarizing the above as simply as possible: for
all those confounded by why not only the US, but the global economy,
hit another brick wall in Q1 the answer was neither snow, nor the West
Coast strike, nor some other, arbitrary, goal-seeked excuse, but China,
and specifically over half a trillion in still largely unexplained
Chinese capital outflows.
* * *
But
wait, because it wasn't just JPM whose attention perked up over the
weekend. This morning Goldman Sachs itself had a note titled "the Curious Case of China's Capital Outflows":
China’s
balance of payments has been undergoing important changes in recent
quarters. The trade surplus has grown far above previous norms, running
around $260bn in the first half of this year, compared with about $100bn
during the same period last year and roughly $75bn on average during
the previous seven years. Ordinarily, these kinds of numbers would see very rapid reserve accumulation, but this is not the case. Partly
that is because China’s services balance has swung into meaningful
deficit, so that the current account is quite a bit lower than the
headline numbers from trade in goods would suggest. But the more
important reason is that capital outflows have become very sizeable and
now eclipse anything seen in the recent past.
Headline
FX reserves in the second quarter fell $36bn, from $3,730bn at
end-March to $3,694bn at end-June. While we estimate that there was a
large negative valuation effect in Q1 (due to the drop in EUR/$ on the
ECB’s QE announcement), there was likely a positive valuation effect in
Q2, which we put around $48bn. That means that our proxy for
reserve accumulation in the second quarter is around -$85bn, i.e. the
actual “flow” drop in reserves was bigger than the headline numbers
suggest because of a flattering valuation effect. If we put that number together with the trade surplus in Q2 of $140bn, net capital outflows could be around -$224bn in the quarter, meaningfully up from the first quarter. There
are caveats to this calculation, of course. There is obviously the
services deficit that we mention above, which will tend to make this
estimate less dramatic. It is also possible that our estimate for
valuation effects is wrong. Indeed, there is some indication that
valuation-related losses in Q1 were not nearly as large as implied by
our calculations. But even if we adjust for these factors, net
capital outflows might conceivably have run around -$200bn, an
acceleration from Q1 and beyond anything seen historically.
Granted,
this is smaller than JPM's $520 billion number but this also captures a
far shorter time period. Annualizing a $224 billion outflow in one
quarter would lead to a unprecedented $1 trillion capital outflow out of
China for the year. Needless to say, a capital exodus of that pace and
magnitude would suggest that something is very, very wrong with not only
China's economy, but its capital markets, and last but not least, its
capital controls, which prohibit any substantial outbound capital flight
(at least for ordinary people, the Politburo is clearly exempt from the
regulations for the "common folk").
Back to Goldman:
The big question is obviously what is driving these flows and how long they are likely to continue. We
continue to take the view that a stock adjustment is at work, although
it is clear that the turning point is yet to come. We will look at this
in one of our next FX Views. In the interim, we think an easier question
is what this means for G10 FX. This is because this shift in
China’s balance of payments is sure to depress reserve accumulation
across EM as a whole, such that reserve recycling – a factor associated
with Euro strength in the past – is unlikely to be sizeable for quite
some time.
In
other words, for once Goldman is speechless, however it is quick to
point out that what traditionally has been a major source of reserve
reflow, the Chinese current and capital accounts, is no longer there.
It
also means that what may have been one of the biggest drivers of DM FX
strength in recent years, if only against the pegged Renminbi, is
suddenly no longer present.
While the implications of this on the global FX scene are profound, they tie in to what we said
last November when
explaining the death of the petrodollar. For the most part, the country
most and first impacted from this capital outflow will be China,
something its stock market has already noticed in recent weeks.
But
what is likely the take home message for non-Chinese readers from all
of this, is that while there has been latent speculation over the years
that China will dump US treasuries voluntarily because it wants to (as punishment or some other reason), suddenly China is forced to
liquidate US Treasury paper even though it does not want to, merely to
fund a capital outflow unlike anything it has seen in history. It still
has a lot of 10 Year paper, aka FX reserves, left: about $1.3 trillion
at last check, however this raises two critical questions: i) what
happens to 10 Year rates when whoever has been absorbing China's
Treasury dump no longer bids the paper and ii) how much more paper can
China sell before the entire world starts paying attention, besides just
JPM and Goldman... and this website of course.
Finally,
if China's selling is only getting started, just what does this mean
for future Fed strategy. Because one can easily forget a rate hike if in
addition to rising short-term rates, China is about to dump a few
hundred billion in paper on a vastly illiquid market.
Or let us paraphrase: how soon until QE 4?
