The roughest ride in global markets isn't over yet

China’s foreign exchange reserves dropped by less than expected in February, falling by only $29 billion, rather than the $70 billion expected by some analysts.

Traders around the world might be breathing a sigh of relief. But economists aren’t giving the all-clear yet.

That’s because one of the root causes of the yuan’s dramatic moves is still very much in play. Very simply, even though it’s not time to panic, money is still leaving China at a record rate.

“…the capital outflow scare is not over yet,” wrote Bloomberg economist Tom Orlik. “February’s figure was flattered by both valuation and holiday effects. Valuation effects likely added about $14 billion to the headline total as both the euro and the yen strengthened against the dollar in February. In January, valuation effects likely subtracted about $3 billion. The Chinese New Year holiday, which meant banks and businesses were closed for a week during the month, was also a factor.”

That means the wildest ride in global markets isn’t over yet, and that the Chinese government will have to continue doing whatever it can (spending even more money), to make sure everything’s under control.

Here’s how it works

China finished February holding $3.202 trillion in foreign exchange reserves, down from $3.231 trillion in January, when $99 billion left the country.

You can see, then, why January was so much crazier for the yuan than February. January was an unholy mess of money leaving the country and downward pressure on the yuan. Since then, the government has taken a more active role in making sure money stays in the country and put pressure on speculators shorting the currency.

The problem, though, is that the measures China has been taking are short term in nature. The root causes of capital outflows and yuan instability remain.

“…China has not yet resolved the underlying problem that triggered the capital flight scare,” Orlik wrote. “It’s close management of the yuan by the PBOC, not restored confidence in China’s growth prospects, that has eased capital outflows. The yuan was effectively repegged to the dollar in mid-January and the PBOC guided it slightly stronger in February.”

The underlying problem of the capital flight scare is the need for tough reforms to modernise China’s economy — to take it from one based on investment, to one based on domestic consumption. This transition is going to require really difficult reforms, specifically, restructuring massive, indebted corporations in collapsing industries like property and manufacturing.

Think about it like a garden. The new plants can’t grow until the weeds are all uprooted.

The Chinese government has talked a lot about these reforms, especially at the National People’s Congress this weekend. But we have yet to see reforms in action. The debt is piling up and the world is getting impatient. Meanwhile the economy continues to slow. At the NPC, leaders discussed monetary stimulus in more detail than they did reform.

Until that happens there will be downward pressure on the yuan and people will want to take their money out of the country. The government will have to use cash to counteract that, and speculators will be waiting to pounce.

All the devils are still here people.

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