China's Use of Derivatives to Hide Capital Flight Comes Unglued; Reserves Fall by Record Amount; "Worthless" Certificates of Confiscation
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China’s Forex Reserves Fall by Record $107.9 Billion
China's foreign-exchange reserves are close to a three-year low, following the largest yearly decline ever.
Capital flight is not only intense, it's accelerating so much that China has undertaken measures to hide the intensity. First, let's consider the flight.
The Wall Street Journal reports China’s Forex Reserves Fall by Record $107.9 Billion on Yuan Fears.
China’s hoard of foreign-exchange reserves continued to shrink in December, recording the biggest monthly drop ever and falling overall to its lowest level in nearly three years as worries intensify over the country’s economic slowdown.Goodbye Reserves
With the $107.9 billion drop in December, Beijing’s foreign-exchange reserves have fallen every month but one since May. The data suggest the central bank is having to spend huge amounts of dollars to support an increasingly beleaguered yuan amid decelerating economic growth and the onset of higher U.S. interest rates.
“It certainly confirms the end of an era,” said Oliver Barron, head of research at investment bank North Square Blue Oak. “What we’ve been seeing is China now becoming an exporter of capital.”
December’s decline brought overall reserves to $3.33 trillion, the People’s Bank of China said Thursday. For the full year, reserves fell $512.7 billion, the largest yearly decline on record. In addition to the PBOC’s spending to support the yuan, some of December’s decrease may have stemmed from depreciating nondollar assets among the central bank’s holdings as the U.S. raised rates last month, analysts said. Higher U.S. interest rates make dollar-denominated assets more attractive to investors.
China's Uses Derivatives to Hide Capital Flight
Chinese capital flight is undoubtedly higher than the Wall Street Journal chart shows. For an explanation, please consider China Finds More Discreet Ways to Support the Yuan.
Just because China is burning through its reported foreign-exchange reserves more slowly doesn’t mean it’s losing its commitment to support the yuan.Mirage of Looking Better
[Mish Note: I was puzzled by Bloomberg's "more slowly" comment before noting the article was from October 20. Clearly some of what China attempted to hide came unglued in December]
The People’s Bank of China and local lenders increased their holdings in onshore forwards to $67.9 billion in August, positions that would boost China’s currency against the dollar. The amount is five times more than the average in the first seven months, PBOC data show. The positions are part of a three-stage process to support the currency without immediately draining reserves, according to China Merchants Bank Co. and Goldman Sachs Group Inc.
Standard central-bank intervention to support a currency generally involves selling dollars and buying the home tender. In this case, China’s large state banks borrowed dollars in the swap market, sold the U.S. currency in the cash spot market and used forward contracts with the central bank to hedge those positions.
"If you can intervene without actually diminishing your reserves, it’s somehow viewed as better," said Steven Englander, global head of Group-of-10 foreign exchange-strategy in New York at Citigroup Inc.
You can't realistically intervene without diminishing your reserve, but you can attempt to make it look that way, for a while, using swap derivatives.
Things looked better, until December and January, when suddenly they didn't.
About Those "Worthless" Certificates of Confiscation
Please recall numerous discussions between 2010-2012 in which various pundits proposed China should sell its US reserves for commodities.
The then going theory was China should sell its reserves for commodities because US Treasuries were "Certificates of Confiscation". Here are some examples.
- May 30, 2012 Bloomberg: James Tisch, the chief executive officer of Loews Corp., said bonds should be called “certificates of confiscation”.
- October 28, 2010 Floyd Norris of The New York Times: Now the government really is selling bonds that deserve the label “certificates of confiscation.”
- May 22, 2008: 2008 Market Oracle: US Treasury Bonds Fast Becoming Certificates of Confiscation. "For bond market players the focus is now on accelerating inflation," said one senior analyst in Tokyo to Bloomberg this morning. Fixed-income investments destroy wealth when the cost of living rises. That's why US Treasuries became known as "certificates of confiscation" during the double-digit inflation of the late 1970s. "The inflation outlook is weighing more on the market as it implies the Fed could hike interest rates," says Linowsky.
- January 21, 2011: Before Its News Wall Street Definition of Bonds: “Certificates of Confiscation” that are “Certifiably Safe” but you lose money on them. Oxymoron, anyone?
For years, decades actually, the consensus opinion was only fools hold treasury bonds.
On August 11, 2011, I too commented on Certificates of Confiscation but in a completely different way.
Citing my friend "BC" whose analysis I happened to agree with, this is what I had to say:
The self-similar secular pattern implies the 10-yr. yield well below 2%, and perhaps below 1.5% along the way, which would imply a trend nominal GDP in the 1% range and core CPI falling to around 0% or negative during a global deflationary contraction.For the record, yield on the 10-year treasury did hit 1.43% in July of 2012. Yield on the 30-year long bond bottomed at an amazingly low 2.25% in February of 2015.
The flattening of the yield curve will squeeze further the net margins of banks and ROA and ROI of insurers and non-bank financial firms, discouraging lending and risk taking.
Yield Curve 1997-Present
Those buying US treasury bonds when others were screaming "certificates of confiscation" at the top of their lungs were duly rewarded.
Selling Reserves to Buy Hard Assets
Had China sold reserves to buy hard assets as many begged China to do, this is what would have happened.
Depending on when and what China bought, it may have had gains or losses. But buying assets when asset prices are high is not a good idea.
Storing huge amounts of oil and some base metals would have been impractical. Moreover, buying items like copper and aluminum would have been very pro-cyclical and would have driven up the price, resulting in even bigger crashes than we have seen.
With rebalancing, China has less need for copper, aluminum, steel, etc.
China could have and should have been slowly accumulating gold over the past decade. Gold is a genuine financial asset.
The price in 2000 was only $250 per ounce. It's still over $1,000 per ounce. Accumulating gold, especially on dips, would have been successful.
Storage costs are minimal. It does not take a lot of space to hold $1 trillion in gold.
Reserves Needed to Defend Against Capital Flight
There is another reason for China to hold huge amounts of reserves, and it's a reason that I have warned about numerous times: China needs reserves to defend itself from capital flight.
Had China used all its reserves or even most of its reserves on hard assets, it would be dumping them now, straight into weakness, to raise those needed reserves.
Another 2% Yuan Devaluation Coming Up?
In case you missed it, please see Another 2% Yuan Devaluation Coming Up? What Are the Risks? Explaining Chinese Capital Flight.
In that post I explain in easy to understand terms pressures on the yuan, capital controls, and how Chinese corporations get around those controls for risk-free profit.
Mike "Mish" Shedlock