One of the most brilliant China minds in the world has a warning for the second half of 2017

BEIJING, CHINA – FEBRUARY 19: Chinese artists perform a dragon dance at a local amusement park during celebrations for the Lunar New Year February 19, 2015 in Beijing, China.The Chinese Lunar New Year of the Sheep also known as the Spring Festival, which is based on the Lunisolar Chinese calendar, is celebrated from the first day of the first month of the lunar year and ends with Lantern Festival on the Fifteenth day. (Photo by Kevin Frayer/Getty Images)

It’s the beginning of the year, and as such, top analysts all over the world are making predictions about what the world will bring.

But not all of them merit as much attention as Autonomous Research’s Charlene Chu, one of the most brilliant minds on China and its debt issues.

In a note entitled ‘The war on outflows,’ Chu laid out her predictions for the year ahead, and two things really jumped out at us.

  1. China’s war on money leaving the country (outflows) is currently being fought with the country’s foreign-exchange reserves and capital controls — that can’t last forever.
  2. China’s future hinges on one wild card — the United States and the dollar.

“China’s authorities have chosen to pursue harsher measures against capital outflows over a large change in the exchange rate to address the country’s outflow problem, at least for now. This could work for a few quarters, but we think closing the gates is not feasible over the long run for the largest trading nation in the world with a USD33trn banking sector. We expect growth to begin decelerating in 2Q17, as a weaker credit impulse passes through, but this is of secondary importance to outflows and the currency,” she wrote [emphasis ours].

Protect your house

In December China experienced $82 billion worth of outflows, the continuation of a troubling trend that has been pushing the value of the yuan, the country’s currency, down.

In order to stem these outflows, the government has instituted a number of capital controls for individuals and corporates. The problem with that, says, Chu, is that eventually those measures will start to hurt the Chinese economy, dampening business sentiment. Foreign direct investment, for example, “has already weakened considerably from less inbound investment and more outbound M&A by Chinese companies.”

And, of course, there’s the fact that the country is draining its $3 trillion in foreign exchange reserves in order to prop up the yuan. Chu estimates that the People’s Bank of China (PBOC) blew through $800 billion in foreign exchange reserves in 2016, which was a year of accelerating GDP growth and another Chinese property boom. If left alone, she believes that keeping up with outflows could eat up half of China’s foreign exchange reserves over the next few years.

What’s more, it seems capital controls are making Chinese households more nervous, not less:

Until recently, the majority of outflows have occurred through corporate channels. It has only been in the last 3-4 months — since the reinstatement of housing purchase restrictions — that we have noticed average urban Chinese citizens becoming more interested in moving their money offshore. If China lost USD800bn last year with limited contribution from households, then the pressure in 2017 ought to be worse. The fact that the authorities have rolled out so many capital flow measures recently would support that

This means ultimately Chinese authorities will have to make a choice — let go of their control of the yuan and interest rates, or end the free flow of capital in and out of the country.

We should also note that Chu sees the The People’s Bank of China hiking rates over the year to keep money in and/or attract investor money to the country, and that will be tough for banks and heavily-indebted corporates.

The Trump card

Chu is an agreement with analysts all over Wall Street on our second salient point, which is that China’s relationship with the US is going to be especially important during this delicate period. A trade war could set of “market jitters” that increase outflows, for example.

“It is this vulnerability to a heightening of market jitters and an intensification of outflow and currency pressure that is our most salient concern with regard to forthcoming policy changes out of the US, not what size hit there may be to GDP,” she wrote.

China has already come up with a few things it can do to strike back at US companies should a Trump administration decide to start a trade war with it. They include levying more taxes and onerous investigations.

Some analysts believe that would only come back to bite China itself.

“When you have a country with a large trade deficit that retaliates against a country with a large trade surplus with it, it’s the country with the trade deficit that wins,” Michael Every, head of financial markets research at Rabobank Group in Hong Kong told Bloomberg. “The country with the surplus loses, every time.”

If Chu is right, China isn’t in the position to take that kind of loss right now, and it may not be for a while.

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