In the face of renewed market optimism, China's continued dramatic under-performance stands out. Most investors remain clueless as to why but the likely reason is simple enough: money outflows. More money is starting to leave China, resulting in less liquidity for the banking system and economy overall. It's a stark contrast to previous hot money flows into China, betting on Yuan currency appreciation. The turnaround has far-reaching consequences. It means China has less scope to ease policy to help its economy. It also means China will print less money to fund U.S. Treasury purchases in the near term. This could well prove a trigger for a global deflationary bust on par with 2008.
China's Slowing Forex Reserves
Most stockbrokers are baffled by the performance of the Chinese stock markets amid what they proclaim is a stabilising domestic economy. What are the markets seeing that they're not? I suspect the answer has a lot to do with money flows.
More specifically, the key story is slowing growth in Chinese foreign exchange (forex) reserves. Recent figures show that this growth is now nearing 0%.
Source: efinancial news
What you'll notice from this chart is that a significant slowdown in China's forex reserves preceded the U.S. tech crash in the 1990s. Then reserve growth ramped up from 2001, in line with global economic growth. Reserves then slowed again in 2008, and we all know what happened to the global economy after that. The latest sharp slowdown in reserves is a far cry from heady post-crisis growth levels of close to 30%.
In my view, the chart demonstrates why Chinese forex reserve growth has probably been the single most important factor in the various asset bubbles of the 1990s and 2000s (U.S. tech, Western consumption, global property) and the subsequent crash. Other factors undoubtedly contributed. But it's hard to see how the asset bubbles could have reached the heights they did without the extraordinary growth in Chinese forex reserves.
To understand why, let's skip back a step. In simple terms, forex reserves are foreign currencies and bonds held by central banks and monetary authorities. What they ultimately reflect though is the supply and demand for a currency. In China's case, there's been overwhelming demand for its currency for a long time. To prevent Yuan currency appreciation and help its export-driven economy, China has printed large bundles of money and bought foreign assets, mostly U.S. Treasury securities.
The ramifications of this strategy have been wide-ranging. An under-valued currency has helped Chinese exporters become ultra-competitive versus other countries. In turn, it's fuelled economic growth, of which export growth has played a large part.
The Chinese buying U.S. Treasury securities has been critical to keeping U.S. interest rates low. And these low rates arguably contributed to the American housing and consumption bubbles. The latter bubble super-charged China's exports and its economy, with the U.S. being China's second-largest export partner. A beautiful system, no?
Now Chinese forex reserves are slowing sharply to levels not seen in the past 15 years. And there's good reason not to expect a bounce back any time soon.
The current slowdown is due to several things. Hot money inflows have slowed. Previously, Chinese firms bumped up their export orders to bring dollars back into the country, betting on a rising Yuan. That's ground to a halt. And inflows were also undoubtedly part of foreign direct investment (FDI), to what extent is difficult to verify. FDI growth has also pulled back.
Chinese are also getting money out of the country. With low deposit rates and real estate prices softening, rich Chinese are getting their cash to safer pastures (particularly the politicians...). This is reflected in negative figures in the "other" column of China's capital account. The trend is ominous, as Victor Shih from Northwestern University in the U.S. estimates the wealth of the top 1% of Chinese is greater than all of China's US trillion in forex reserves.
These are just two of the factors behind the slowdown. It's important to note that China appears vulnerable to further potential deceleration in forex reserves.
Xi Jinping's in a Tough Spot
Money outflows are squeezing China's balance sheet at a time when its economy is under immense pressure. Slowing forex reserves are already having a direct impact on liquidity in the banking system, evidenced by slowing deposit growth. Banks are being forced to fund themselves on the interbank market and via short-dated loans. Less liquidity also goes some way to explaining the continued under-performance of Chinese stock markets.
The government does have a few options to stimulate the economy; none of them pretty. Cutting reserve ratio requirements for the banks and conducting reverse repo operations in a piecemeal way aren't going to cut it though.
The government could undertake a large asset purchase program, aka quantitative easing. But this could lead to expectations of currency depreciation and further possible money outflows.
It could also aggressively cut reserve ratio requirements for banks and interest rates. Whether there's end-demand for credit though is questionable.
All of this leaves China with few good options at present.
Trigger for Broader Crash?
Money outflows from China not only impact China itself. With China recently recording a balance of payments deficit (value of imports exceeding exports), it's reduced the need for the country to print money to maintain currency stability. And it's subsequently reduced China's need to buy foreign assets. This means that there could be a further acceleration in China being a net-seller of its favourite foreign asset, U.S. Treasuries.
Given China is the second largest holder of U.S. Treasuries, and it'll likely be a net seller going forward, this means the U.S. will need to find other ways to fund its debt. The most likely option is that domestic savers in the U.S. will fill the gap. Such an outcome would reduce private sector credit to finance government needs. This would be profoundly deflationary.
The other broader point, as noted by CLSA Strategist Russell Napier, is that the world's money supply growth has primarily relied on China in recent years. Since 2007, the U.S. has only accounted for 15% of total money supply growth, while China has accounted for 45% of the total!
Without China fuelling the world's money supply via printed Yuan, the big question is who can pick up the slack. Europe appears highly unlikely given its austerity measures. The U.S. and Japan maybe, but remember the latter has tried massive quantitative easing to increase money supply before (2001-2006) and failed miserably. Any way that you cut the numbers, global money supply is in trouble without China's continued contribution. This means another global deflationary shock in the not-too-distant future shouldn't be ruled out.
What to Own
For some time, I've argued that the western world is entering the same traps of zero-bound interest rates that Japan fell into. Like Japan, it's finding out that it isn't easy inflating out a major credit bust.
The endgame is likely to be a deflationary bust or serious inflation/hyperinflation. In many respects, these scenarios are two sides of the same coin and one could well follow the other.
China's forex reserve slowdown may hasten this endgame.
Under these circumstances, where do you invest? Well, your goal should be preserving your hard-earned money. I've argued previously that cash, principally the Singapore dollar, and gold should be core holdings. Under the two scenarios presented above, these two assets are likely to hold you in good stead. Equities would be big losers in either scenario. And bonds would potentially prove profitable under deflation, but with rates so low and the debt loads of many countries so high, they're much less attractive.
Source: Asia Conf.
