The Fragile State of China’s FX Reserves

Here are the bullet points from an interesting presentation by Northwestern University’s Victor Shih from this past weekend’s INET conference in Bretton Woods (hat tip Scott):

• China has three structural causes of capital flight. First, wealth in China is highly concentrated. Using three different methodologies based on survey data, data on large share holders of listed company, and data on the total financial and real estate assets in China, the wealthiest 1% urban households command between 2 and 5 trillion USD in wealth.
• A 20% reallocation of this wealth overseas would cause a substantial but likely controllable drainage of China’s foreign exchange reserve.
• A 30-40% reallocation of this wealth overseas would see the depletion of China’s foreign exchange reserve by close to 1 trillion USD or more.
• Second, underground banks, false trade invoicing, and now an experimental scheme to allow individual investors to invest overseas provide multiple channels for capital to circumvent China’s exchange control.
• Third, real deposit interest rates are negative and will remain so in the foreseeable future, thus prompting wealthy households to speculate overseas on a large scale if relative returns suddenly decrease in China.
• If the top 1% of households in China reallocates 1 trillion USD of their wealth overseas, the central bank then will be faced with a choice between large scale quantitative easing and an illiquid banking system.
• In the short term, China’s only recourse to reduce the volatile state of its foreign exchange reserve is to bring real interest rates back to positive territory.

The associated video and presentation are below.

UPDATE: Having discussed this a bit with some people who know capital markets, here is a bit of pushback on this idea.

Marshall Auerback noted that:

If you had huge capital flight as Shih suggests, the implication is that the yuan gets much weaker, as presumably these yuan are exchanged for other assets or currencies. But if that happens, wouldn’t you also get a large corresponding rise in exports (until, of course, Congress or the EU goes nuts and stops the process), which would begin to rebuild the reserves?

What Marshall means is that a property collapse and the resultant capital flight would make the Chinese peg go from overvalued to undervalued in a hurry. Would you see the Chinese devalue instead of revalue? And if so, what would be the political consequences of such a move. Both Marshall and Yves Smith have pointed out this scenario in the past as one to consider.

Where would that fleeing capital go – into US Treasuries, commodities, gold, silver? My first guess would be gold. If it were commodities, what would that mean about the already difficult inflation problem? Another commenter said:

One wonders why (or whether) capital flight has not been ongoing – real deposit rates have been negative for some time. It is part of the reason why saving takes a real form in property overbuilding.

If this is the case and a property crash happens, would we see debt distress that unwinds these trades. For example, there have people using commodities as collateral for loans. Who are these people and where is their money parked? I could see a need for these individuals to actually buy RMB to unwind their speculative commodities play, that is if the capital flight has already occurred.

Yves brought up the important point of liquidity:

I’m not certain how liquid the top rich really are. There is LOTS of evidence that they have been putting their wealth in real estate, the stock market, and commodities hoarding. None of these lend themselves to capital flight. So I think the much bigger first order issue would be an implosion of the RE bubble, that could feed on itself much faster than any effort to move funds overseas, which remember is a difficult and time consuming process given the capital controls.

She also mentions inertia as a factor. Moving a third or even 20% of your portfolio is a big move. What kind of pre-conditions would make that a likely scenario?

In the end, just because we are thinking about this doesn’t mean we have it all figured out. There are still a lot of unknowns.