This Is How China Hides Its Capital Outflows
This Is How China Hides Its Capital Outflows

For China, things have been going according to plan in recent weeks. Despite the slowing economy and more stimulus, bad news about capital outflows have abated.

Instead, the regime successfully leaked its plans to fully float the yuan by 2020. This is probably an effort to convince the International Monetary Fund to include it in its global reserve currency this month.

However, some cynics might say the float will come sooner rather than later and not by choice. As much as $850 billion in capital left China by the end of September 2015, putting huge pressure on the currency.

The country may be hiding even more capital outflow through derivative contracts.   

Judging by the example of Brazil, this practice probably won’t end well. “They are using forwards like Brazil does. This masks the capital outflow because they are getting banks to short the dollar on paper. That is what Brazil did and it was a disaster,” said Jeffrey Snider of Alhambra Investment Partners.

In layman’s terms, this means the regime is forcing state-controlled banks to enter into derivative transactions—a bet purely on paper—to push up the value of the yuan, rather than outright sell foreign exchange reserves.

This practice can mask the reserve drain until the forward positions are unwound, because derivative contracts by private banks aren’t often reported publicly.

“If you can intervene without actually diminishing your reserves, it’s somehow viewed as better,” Steven Englander, global head of Group-of-10 foreign-exchange strategy in New York at Citigroup Inc. told Bloomberg.  

According to the latest data from August, the People’s Bank of China (PBOC) and onshore banks increased their holdings of yuan forwards (a derivative contract based on the currency) by $67.9 billion.

Goldman Sachs suspects the PBOC might help banks to hedge their risk exposure: “The large gap between [September’s outflow data] and the other PBOC data for September suggests that banks might have used their own spot foreign exchange positions to help meet some of the outflow demand. Banks’ overall foreign exchange positions might still have been squared with the PBOC via forward agreements,” Goldman wrote in a note to clients.

This is exactly what Brazil did in 2013 and it didn’t work out in the long-term, explained Snider:

“They manipulated the onshore rate so the local Brazilian banks had an incentive to increase their short-dollar positions via derivatives. The dollar problem goes away for a while. Then a lot of those swaps and forwards are coming due. They are inefficient and expensive from the central bank perspective, so they stopped rolling them over. Without the artificial incentive, the real just tanked.”

Indeed. In the chart below, the Brazilian real briefly rallied in the summer of 2013 and held stable for most of 2014 before crashing 40 percent in the last 12 months. The underlying economic problems—ironically closely tied to a slowdown in the Chinese economy—just hadn’t been fixed.

Brazilian Real in U.S. Dollars (Google Finance)
Brazilian real in U.S. dollars. (Google Finance)

November is going to be an interesting month for China as the IMF is due to make its decision about the country’s inclusion in the elite of global finance. We are also waiting for new data on foreign exchange reserves to come out.

In the meantime, the global currency used to funnel money out of countries with capital controls (Venezuela, Cyprus) has doubled since the Chinese economy started to unwind in the middle of July 2015. It’s not the U.S. dollar—it’s the digital currency bitcoin. 

It’s hard to say how much money has left China via bitcoin. The alternative currency only exists as a digital code on the so-called blockchain, a central processing mechanism. It is also hard for authorities to trace, which is why it was used by Russians to get money out of Cyprus in the spring of 2013, when the small Mediterranean country had deposits frozen as part of a bailout by the European Union and the IMF. Bitcoin rallied from $13 to $121 in the wake of the Cyprus crisis.

If the Chinese start using bitcoin to get capital out in earnest, we could see its value similarly soar.

The price of Bitcoin in U.S. Dollars in 2015 (Google FInance)
The price of bitcoin in U.S. Dollars in 2015. (Google FInance)
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