Record capital flight from China as industrial slump drags on

China's state media decries "unimaginably fierce resistance" to economic reforms, a sign that president Xi Jinping is becoming furious with incompetent party officials

China's Vice President Xi Jinping casts his ballot during the closing session of the 18th National Congress of the CPC at the Great Hall of the People in Beijing...China's Vice President Xi Jinping casts his ballot during the closing session of the 18th National Congress of the Communist Party of China (CPC) at the Great Hall of the People in Beijing, in this November 14, 2012 photo released by China's official Xinhua News Agency. The congress started its closing session on Wednesday morning, at which a new CPC Central Committee and a new Central Commission for Discipline Inspection will be elected.     REUTERS/Xinhua/Li Xueren (CHINA - Tags: POLITICS ELECTIONS TPX IMAGES OF THE DAY) NO SALES. NO ARCHIVES. FOR EDITORIAL USE ONLY. NOT FOR SALE FOR MARKETING OR ADVERTISING CAMPAIGNS. THIS IMAGE HAS BEEN SUPPLIED BY A THIRD PARTY. IT IS DISTRIBUTED, EXACTLY AS RECEIVED BY REUTERS, AS A SERVICE TO CLIENTS. CHINA OUT. NO COMMERCIAL OR EDITORIAL SALES IN CHINA. YES
China's President Xi Jinping

Capital outflows from China have surged to $190bn over the last seven weeks, forcing the authorities to intervene on an unprecedented scale to defend the Chinese currency.

The exodus of funds is draining liquidity from interbank markets and has pushed up overnight Shibor rates by 30 basis points in the last ten trading days, a sign of market stress.

Yang Zhao from Nomura said $90bn left the country in July. The pace has accelerated since the central bank (PBOC) shocked the markets by ditching its currency peg to the US dollar.

Capital flight for the first three weeks of August is already close to $100bn, despite draconian use of anti-terrorism and money-laundering laws to curb illicit flows.

Mr Zhao said the PBOC had intervened “very aggressively” to stabilise the currency and prevent the devaluation getting out of hand, but this automatically tightens monetary policy.

The central bank will almost certainly have to cut the reserve requirement ratio (RRR) for banks to offset the loss of liquidity, with some analysts expecting action as soon as this weekend.

The PBOC’s latest report calls for “monetary easing”, dropping the usual caveat that measures should be targeted. It is a sign that Beijing is preparing blanket stimulus, despite worries that this could lead to a repeat of the credit excesses that have haunted China since the post-Lehman boom.

The PBOC has already injected $160bn into the China Development Bank for projects.

Hopes that China is at last shaking off a recession in the first half of the year – caused by a combined monetary and fiscal crunch - have once again been dashed by grim manufacturing data.

The Caixin PMI survey slumped to 47.1, far below the boom-bust line of 50 and the lowest since March 2009. New export orders slid further to 46.0 while inventories are rising, a nasty cocktail.

Caixin Insight said the bad figures reflect the tail-end of a downturn that has largely run its course as stimulus kicks in. "The economy could be in the process of bottoming out and may start to rebound within the next few months," it said.

The ructions in China come at a moment when markets are already bracing for the first interest rate rise by the US Federal Reserve in eight years, a move that threatens to tighten the noose further on over-stretched emerging markets (EM) and the commodity nexus.

Danske Bank said the latest rout is worse than the “taper tantrum” in 2013 when the Fed first hinted at tightening, and is quickly turning into a “perfect storm” as the Turkish lira, Brazilian real, Malaysian ringgit, and Russian rouble all go into free-fall.

Capital outflows from emerging markets have reached $940bn since June 2014, according to NN Investment Partners. The damage from the EM crisis is ricocheting back into the US. High-yield bonds spreads have surged to three-year highs, rising to bankruptcy levels of 1100 basis points for energy companies.

It is unclear where China’s political system is now heading. The country is gripped by an anonymous article published in the state newspapers warning that the reform process faces “unimaginably fierce resistance”

Jonathan Fenby from Trusted Sources said the article is a sign that a furious President Xi Jinping is losing faith in his officials after a secret conclave of the party leadership in August. “Behind the confident front which he presents to China and the rest of the world, factionalism is still alive within the senior ranks,” he said.

The botched handling of the Shanghai equity crash has raised serious doubts about the competence of the Chinese leadership. The conclave report urged “drastic and pragmatic reform” of the state-owned enterprises, fiscal policies, finance, and the judicial system.

There is little doubt that the party committed grave policy errors over the winter months, culminating in the so-called “fiscal cliff” as a botched reform of local government finance caused spending to collapse. The question is whether the worst is over as the authorities launch another stop-go cycle.

Credit growth rose to a 31-month high in July, though a chunk of this is simply rolling over old debts to keep the game going.

Fiscal spending is picking up sharply as the new bond market finally comes on stream. Local governments issued almost $200bn of securities in June and July, a blistering catch-up pace.

Simon Ward from Henderson Global Investors says his measure of the money supply – “true M1” – has recovered after turning negative late last year for the first time this century.

It has been rising at an annual pace of 10pc over the last six months and is accelerating, pointing to a lift-off in growth later this year. His measure includes household demand deposits.

Yet capital flight greatly complicates the picture. It comes at a time when the Shanghai composite index of stocks has dropped back to 3,507, retesting the post-crash lows of early July. There is a pervasive fear that the crisis may be deeper than admitted so far by the Communist Party.

The PBOC has clearly been caught off-guard by the violent reaction of the markets to its new exchange rate regime, widely suspected to be a disguised move to devalue the yuan and rescue struggling exporters. It has had to step in to stabilise the currency near 6.40 to the dollar, containing the devaluation at 3pc.

Shanghai Composite

Nomura said these conspiracy theories are misguided. The PBOC had to act to bring exchange rate policy into line with other reforms of China’s capital account or face mounting complications. It is a healthy development.

The PBOC was faced with the “Impossible Trinity”, a textbook case in economics where you cannot control capital flows, monetary policy, and the currency, all at the same time. One has to give.

“Unless they opened up the exchange rate, they were going to lose monetary policy independence. It was quite urgent,” said the bank.

Michael Kurtz, Nomura’s Asian equity strategist, said markets have misread what is happening on the ground in China, pricing in a doom scenario that is unlikely to happen. “This represents a buying opportunity. We think stocks will end materially higher at the end of the year,” he said.

The ugly PMI figures overstate the weakness of the economy. Premier Li Keqiang is deliberately shifting resources away from the old industrial sectors. The “trade-intensity” of Chinese growth is plummeting as the country matures.

The Chinese people have hardly felt the effects of their slowdown so far. The pain has been exported to Brazil, South Africa, Australia, and other countries that live off China’s commodity demand.

Bo Zhuang from Trusted Sources said the stability of the jobs market is the “ultimate bottom line for the Chinese leadership”. Employment is so far holding up well. A net 7.2m jobs were created in first half of the year, enough to meet the annual target of 10m.

However, the ratio of vacancies to applicants peaked at 1.15 late last year and has since dropped to 1.06, the steepest fall since the Lehman crisis. One of the weakest components of Friday’s PMI survey was employment, so the ratio is likely to fall further.

The Chinese authorities have manoeuvred themselves into a corner. With hindsight they liberalised the exchange regime too soon, before the fiscal recovery had fed through and before it was clear that the recession was safely over.

They have now to contend with accelerating capital outflows that they themselves provoked, and that make it even harder to manage the downturn. Xi Jinping has every reason to be exasperated.