Is the $1tn China carry trade imploding?

Is the $1tn China carry trade imploding?

James Kynge | Feb 06 2015

China is not short of economic headaches.Overborrowed and overbuilt, its parlous state prompted the World Bank last month to warn of the potential for a “disorderly unwinding of financial vulnerabilities” that could clobber global growth.

The admonition assumes extra significance as a swelling torrent of “hot money” cascades out of China, depriving some of the country’s most risky assets of the liquidity that has kept valuations buoyant over the past few years.

Source: Societe Generale

In the fourth quarter of last year, net outflows from China’s capital account reached a record of $91bn, following an outflow of $56.7bn in the third quarter.

The chart to the left shows the impact that the receding funds are having on the capital account, creating a “new normal” of quarterly deficits and driving down China’s vast stock of foreign exchange reserves, which currently stand at $3.84tn.

Analysts say these outflows reveal an unwinding of the “China carry trade”, through which speculators have borrowed short-term from overseas banks at relatively low interest rates and then invested in high-yielding Chinese assets amid expectations of a renminbi appreciation.

“As for the source of outflows, we believe that the unwinding of carry trades, and other speculative short-term flows, has played a major role,” said Jason Daw at Societe Generale in Singapore. “Outflows in those short-term accounts are likely to remain sizeable,” he added.

How big is China’s “carry trade” vulnerability?In the aftermath of the 2008 crisis, Chinese financial and corporate entities have binged on overseas short-term debt. According to Bank of International Settlements (BIS) data, outstanding debts of less than one-year maturity rose by seven times in less than six years from $121bn in March 2009 to $850bn in September last year.

Source: Citi

The unusual thing about China, says David Lubin, head of EM economics at Citi, is not only the intensity of the borrowing spree, but also the very high proportion of short-term borrowings relative to a total just over $1tn in foreign liabilities (roughly 10 per cent of China’s GDP).

The chart to the left shows short-term debt accounting for 80 per cent of the total – significantly higher than any other emerging market.

Lubin, Daw and several other analysts think that most of this short-term debt was invested inside China in various high-yielding and “shadow finance” instruments. Wealth management products, generally issued by banks, have usually yielded between 4-6 per cent while trust products, generally considered part of the “shadow” system, have returned between 8-11 per cent over the past couple of years, according to China Confidential, a research service at the Financial Times.

The allure of such returns was sharpened still further when the renminbi was in ascendance against the US dollar. Thus, “carry” investors could hope for a return of several percentage points over the cost their US dollar borrowings.

But now, Lubin said, all is in flux. The three foundations of the “carry” story – the likelihood of renminbi appreciation against the US dollar, sustainably low US dollar funding costs and a vibrant Chinese shadow financial system – have fractured. “All three of the factors that were sucking money into China are now weakening,” he said.

However, none of this means that a disorderly unwinding of $850bn in short-term borrowings is necessarily in prospect. With $3.84tn in foreign currency reserves, “a large speculative outflow from China can easily be financed by the central bank,” Lubin says.

Renminbi likely to weaken furtherNevertheless, if the era of “peak carry” is past and capital outflows have become a “new normal”, the impact upon China’s monetary and exchange rate policies may be profound.

Source: Societe Generale

The most immediate impact is to undermine the renminbi, which has depreciated against the US dollar by about 2 per cent since September last year.

Several analysts see this trend continuing as China seeks to recover some of the export competitiveness surrendered to Asian and European rivals, whose currencies have slumped by greater margins against the dollar (see chart above, showing the renminbi’s appreciation against a basket of currencies).

“China has a surplus and the capital wants out,” said Charles Dumas, chief economist at Lombard Street Research. “If you take a 12 month view, our view is that the renminbi will be significantly down.”

Achilles Risvas of Dromeus Capital Management said: “They can extend and pretend for a while, defending the renminbi against the dollar. But it is in their interest to burst the bubble a little and allow the currency to depreciate, thereby leading to a drop in asset prices.”

In its actions so far, at least, Beijing appears intent on making the renminbi’s easing against the greenback a gradual affair. The fact that the foreign assets of the People’s Bank of China’s (PBoC), the central bank, contracted by Rmb128.9bn in December shows that the authorities have been actively intervening to stall their currency’s slide, Daw said.

“Carry” unwind fuels a monetary policy dilemmaIn an economy engorged by debt – currently estimated to amount to around 240 per cent of GDP – China faces the threat that if liquidity depletes sharply, it may depress growth. Thus Beijing has to find a way to replenish the liquidity lost through capital outflows.

One option, analysts said, would be to cut interest rates, invigorating companies by reducing their debt service burden while making it cheaper to borrow. But this course of action may also depress the renminbi, triggering further outflows as investors dump the “carry”.

This is the reason why, analysts said, Beijing decided this week to cut its bankrequired reserve ratios (RRR), a move that does not involve altering interest rates but nevertheless replenishes liquidity lost through capital outflows by liberating effectively frozen deposits in the banking system.

It may not be a coincidence that the estimated Rmb500bn in liquidity that the RRR cut is set to infuse into the financial system is not far short of the Rmb569bn ($91bn) that was lost in the fourth quarter through outflows.