As Chinese capital flees, impact can be major -James Saft

September 8, 2015

Sept 8 (Reuters) – How sellers of everything from Maui real
estate to fine art reinvest the proceeds will be key in
determining the global impact of Chinese capital flight.

That is, of course, if China carries on allowing capital to
flee, far from a certainty.

China logged its biggest-ever fall in foreign exchange
reserves in August, down $93.9 billion last month to $3.557
trillion as it battled a slide in the yuan prompted by capital
flight, People’s Bank of China data showed on Monday.

How, for how long and under what rules of engagement China
fights this battle will matter a great deal for it and the
global economy.

Where the money leaving China goes, what it buys and what
those who sell to Chinese capital owners do with the cash will
also have a big impact; potentially changing the global price of
money and with it the price of financial assets.

Money leaving China does so for a complex set of reasons.
Some individuals fear further devaluation of the yuan and falls
in Chinese asset prices and go abroad seeking better
investments. Some, especially those with fears over corruption
prosecution and the rule of law, seek safety, often by buying
property in places like London, New York, Hawaii or Canada, or
even art. Property can act as an escape hatch as well as a store
of value, while art is easy to store and easy to own
anonymously.

To understand the impact these flows might have on markets
it is important to remember how and why China built up the
largest foreign exchange reserves in history, and what it bought
on the way up.

The foreign exchange pile was largely built up in an effort
to hold down the value of the yuan and support exports. To do so
China needed to hold on to many of the dollars it earned in
exchange for exports. The PBoC did this not like a pension fund,
seeking to maximize risk-adjusted return, but simply with the
economic and exchange rate management as a goal. The result was
that China became the biggest creditor to the United States,
owning at least $1.5 trillion of U.S. debt.

So when money flows out of China, as it is now, the PBoC
must either allow the yuan to fall in value or stabilize it by
selling reserves, mostly Treasuries, and handing over the cash
to owners who are expatriating it. The vast majority of this is
done against regulations, but happens none the less.

DIFFERENT PREFERENCES

While the amount of dollars doesn’t change, the preferences
of these dollar’s new owners is likely to be hugely different.
Some Chinese will park some of their money in Treasuries, but
many will instead buy real estate, art or other assets.

“If China is forced to significantly run down FX reserves to
defend its economy from disorderly capital outflows (which we
believe would be dominated by domestics looking abroad as
opposed to foreigners repatriating) and undesired currency
depreciation, then this could have a notable impact on the U.S.
term premia,” economists at Societe Generale led by
Michala Marcussen wrote in a note to clients.

“However, that would depend also on which assets capital
outflows seek out; if the Chinese private sector buys U.S.
Treasuries as the official sector sells then it is merely a swap
of Chinese external assets from the public sector to the private
sector. In the real world, such perfect matching is unlikely.”

This is where the preferences of the sellers of Picassos and
luxury apartments come in. They too are unlikely to want to turn
their new cash piles into exclusively liquid Treasuries. The
upshot is a drop in overall supply of Treasuries offered,
combined with a drop in demand, forcing interest rates up or
increasing longer-term rates particularly.

Remember too that the 10-year Treasury price is
sometimes called the most important price in the world for a
reason. Treasuries have a special power of influencing the value
of other assets in financial markets. The higher the price of
Treasuries, the cheaper other, riskier assets look in
comparison. Reverse the first part of that and you reverse the
second.

The trend of capital flows does not appear over.

“The evidence indicates not that the market is settling back
down but rather that the market is betting more and more against
the RMB stabilizing. Capital appears to be flowing out at a
faster rate,” writes Christopher Balding, an associate professor
at Peking University HSBC Business School. www.baldingsworld.com/

The open question is how China might try to stem flows,
though many of those efforts may only make money more eager to
leave.

From Maui to Wall Street, the impact will be large.

(At the time of publication James Saft 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 and find more columns at blogs.reuters.com/james-saft)

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(Editing by Dan Grebler)

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