As Chinese capital flees, impact can be major

September 8, 2015

By James Saft

(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. Hemay 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) ((jamessaft@jamessaft.com))

(Editing by Dan Grebler)

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