Capital flight from China may deal another blow to global financial markets, raising US interest rates above where they would otherwise be at a sensitive time.
Massive amounts of capital are leaving China, driven variously by fears of a slowdown, of a falling yuan and of a corruption crackdown, with some estimates putting the figure for 2015 at or above US$1trn.
As capital leaves, China’s foreign exchange reserve managers must either sell some of the US$3.3trn in assets they have stockpiled or allow the yuan to weaken. As a weakening yuan, while helping exports, can become a self-fulfilling spiral, China has resisted allowing market forces to play their role.
“It’s ridiculous. It’s impossible,” Han Jun, deputy director of the office of the Chinese Communist Party’s Leading Group on Financial and Economic Affairs, said on Monday when asked about further falls in the yuan.
“China still maintains a huge capital inflow,” Han said, taking a somewhat lonely position amidst evidence to the contrary.
China’s resolve to support the yuan implies further selling of US assets, particularly Treasuries but also corporate and other types of debt. As bonds are sold, it will press yields higher than where they would otherwise settle.
That’s not to say US interest rates will go up; the overall impact of China is clearly deflationary. Instead, the normal boost the economy might get from falling Treasury yields will be blunted. Treasuries, on some measures, had their strongest opening week of a year ever in 2016, while stocks had their weakest. Yet Chinese official selling may actually have capped bond price gains as well as the fall in yields.
This also underscores the extent to which the Federal Reserve, which raised interest rates for the first time in a decade in December, faces challenges to its control over yields, which are its principal means to steer the economy.
“In my view, the downside risks relate mostly to the influence of the rest of the world on our economy,” Atlanta Federal Reserve President Dennis Lockhart said on Monday.
“Last week we saw a global sell-off in stock markets apparently triggered by data from China that fell short of expectations.”
Data last week showed China’s foreign exchange reserves fell by the most on record, US$108bn in December alone. Reserves dwindled by more than half a trillion dollars for the year.
Massive sales
Bank of America Merrill Lynch estimates that China sold US$292bn of US Treasury debt last year as well as US$3bn of US agency bonds and US$170bn of non-US assets. BAML on Monday predicted that US corporate bonds could prove vulnerable to Chinese sales. China holds more than US$400bn of US corporates, the bank estimates.
Swap spreads, the extra that an investor gets for accepting a floating payment from a bank rather than a Treasury yield, have narrowed in recent weeks, a trend tied to Chinese selling. As of Monday two-year swap spreads were down to nine basis points, as compared to about 24bp a month ago.
At various points last year swap spreads were actually negative, a bizarre condition considering that banks are far riskier counter-parties than the US government.
To be sure, US borrowing rates remain extremely low. Ten-year Treasuries yield just 2.17%, and two-year notes 0.93%.
This is really simply the flip-side of the phenomenon of Chinese reserve accumulation over the last 15 years, a trend which arguably also drove US interest rates too low, despite Fed efforts. That was one of the underlying causes of the US housing bubble, and may also have contributed to the earlier dotcom bubble, as investors took on risk and borrowers found money too cheap not to borrow.
Still, it is important not to understate the extent to which China’s management of its foreign reserve assets can complicate US economic management, not to mention muddy the waters in global financial markets.
China, a great importer of raw materials and exporter of finished goods, is sending deflationary waves globally already. That China might depress demand for US products while at the same time, on the margins, raising the cost of financing for dollar-based borrowers only makes the Fed’s position more thorny.
Chinese selling of Treasuries and other fixed income will also tend to up-end investor expectations of how their portfolios will perform in times of market stress.
With no signs that capital flight pressure will diminish, China will remain one of the main market and economic risks in coming months.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
