Chinese markets on Friday led the world in a hair-raising sell off that continues to this moment.
The Shanghai Composite, after already taking a beating during July’s sell off, has now erased its gains for 2015.
The government’s measures to stop the bleeding didn’t stop it earlier this summer, and they don’t seem to be stopping it now.
But that doesn’t mean the government has stopped trying to use its $US3.6 trillion in foreign-exchange reserves to calm the chaos. And that huge number has been a comfort to observers around the world.
But the true picture of China’s fortress foreign-exchange reserve pile is actually far more complicated than that. China’s reserves have been taking a hit from massive capital outflows for months now. Over the last seven weeks alone, $US190 billion has left the country.
This is the number to watch. With every month, that reserve pile dwindles at an accelerated rate. Panic only makes that rate accelerate even more. Capital flight for the first three weeks of August has already reached about $US100 billion.
And while China has a $US3.6 trillion on paper, that’s very likely not the real number the People’s Bank of China is working with in cash. To put it simply, it is one thing to have the money, and it is another thing to have the money on hand, especially when the country is in emergency mode with no end in sight.
In a recent research note, star China analyst Charlene Chu of Autonomous Research posited that a lot of China’s foreign-exchange reserves are tied up in illiquid assets. As such, it’s unclear how much money China will have to make the grand gesture the market seems desperate for.
What is clear is that it isn’t $US3.6 trillion. It could be far less.
And if it is, then China may have less time to plug the holes in its economic ship — which include an overall economic slow down and a currency devaluation — than everyone thinks.
An era of outflows
Before we get into that, though, you’ve got to understand what has been happening to China’s foreign-exchange reserves for the past year or so.
China’s reserves have been dropping at a rapid rate since 2013. Since then it has lost about $US750 billion to capital flight as investors have grown wary of China’s growth model. Goldman Sachs said in a July note “that capital outflows have become very sizable and now eclipse anything we’ve seen in the recent past.”
It’s clear from Chu’s note that she does not believe this trend will end anytime soon. In fact she calculates that by 2018 all of China’s excess reserves — cash that it has on hand to use immediately — could be gone.
Now the situation is likely more dramatic. Chu’s note was written before the country devalued the yuan — a measure that is sure to spur capital flight as investors convert their cash into a currency that isn’t losing value.
When she wrote the note last month, Chu posited that the government only has around $US667 billion in excess foreign-exchange reserves to toss around, out of $US3.6 trillion.
She calculated that by factoring in precautionary cash requirements the government needs to keep on hand, as well as almost $US900 billion in illiquid assets, that it can’t access immediately.
Those illiquid assets mostly consist of investments in things like natural resources and the Asian Infrastructure Investment Bank.
To the rescue
The rest of China’s foreign-exchange reserves can be put to work, which is exactly what the government has been doing.
On Tuesday, it injected $US48 billion into the China Development Bank and $US45 billion into the Export-Import Bank of China.
And, given the crisis at hand, there will be more work to do. Analysts polled by Bloomberg think it will take an additional $US40 billion a month to keep the yuan where the PBOC wants it through 2015. So add that to the pile.
Also, we don’t know exactly how much money the government is using the prop up the stock market, but it’s probably a pretty penny. Rallies like the one we saw on Wednesday — when the Shanghai Composite started the day down 5% only to rally gloriously, ending the day up 1.24% — don’t come cheap.
Business Insider reached out to another expert to see if there might be more to consider in terms of how much of China’s reserves can used in the event of an emergency, and we got a complicated answer — one that only reinforces that the scariest, most mysterious factor in the world of money is always time.
Professor Christopher Balding, a political economist at Peking University, pointed out that the China Investment Corporation actually borrowed most of its capital from the PBOC in the form of USD bonds.
“I don’t know the specific amount, but it is probably fair to say that that compromises almost 20-25% of the PBOC reserves,” he said.
Of course, if you’re the Chinese government you might already be working as quickly as possible (remember, time is everything) to convert illiquid assets into cash you can hold. But even with assets as liquid as US Treasuries, that work is not as easy as you might think.
Balding put it to us like this: “If you believe that US Treasuries are less than completely liquid, you are probably almost at 50% of the PBOC reserves being less than completely liquid,” he wrote in an email to Business Insider.
“What I mean by the Chinese [US] Treasury holdings is this: a) If China is just going to sell USD cash to prevent RMB from falling, they can sell USD cash really anywhere in the world. However, b) if they want to sell their US Treasuries in any significant amount, they have to sell the Treasuries to obtain the USD cash and then sell USD cash to maintain [the yuan].”
That kind of movement in the market would be detected by traders around the world the same way sharks smell blood in the water.
“If China really moved to dump large amounts of Treasuries rapidly,” Balding continued, “that would really cause problems and be detected. They are probably liquidity constrained.”
But they’re also obviously time constrained.
Don’t say it …
So the real danger here is in an emergency — a stock slide, a property-market bust, or a surge in capital flight.
One thing that will contribute to capital flight is a weakening yuan. If people think the Chinese currency is going to keep losing value, they’re going to want to convert it into something else, like dollars or euros.
“The risk is that depreciation triggers capital flight, dealing a blow to the stability of China’s financial system. Our calculation is that a 1% yuan depreciation against the dollar triggers about $US40 billion in capital flight,” Bloomberg economist Tom Orlik wrote in a recent note.
Another measure that could encourage capital flight is a rate cut. China has done four since last fall, and Wall Street fully expects another one. In fact, rumours that a cut could be coming as early as this weekend helped fuel China’s stock market rally on Wednesday.
A rate cut means that money in China will yield less for investors — another reason for them to take their money out of the system.
If capital flight kicks up dramatically, that’s when China might have to enact some capital controls.
But you know the first rule of capital controls.
Never talk about capital controls.
That only scares people.