Ever since the Chinese economy started slowing and the country surprised markets with a currency devaluation in August, analysts have been scrambling to lower their estimates for pretty much anything concerning China.
Since June this year, some estimates put the total number of outflows as high as $300 billion. In order to service the outflows and stabilize the exchange rate, China has had to sell about $400 billion in foreign exchange reserves since August 2014. This number could reach $1.2 trillion in a “downside scenario,” according to Barclays.
“In such a downside scenario there could be pressure on the central bank to provide about 10–12 percent of GDP [up to $1.2 trillion per year] in reserves to the market to offset outflows as well as hedging demand,” the bank wrote in a note.
The analysts particularly highlight the fact China will have to pay back a large chunk of $1.4 trillion of external debt within one year. Repaying external debt means taking money out of the country and moving it offshore to settle the repayment, a net outflow.
External debt has been on the rise during the past years as Chinese companies used cheap interest rates in U.S. dollars to make up for falling exports.
As the export sector has cooled down over the past years, fewer dollars entered the country. The problem is that most of this debt is short-term and the borrowers will have to repay soon.
According to the analysts, this is the unwind of the infamous carry trade. Companies not only used the borrowed funds to finance trade but also borrowed heavily in U.S. dollars. Chinese and international speculators also borrowed U.S. dollars cheaply to fund purchases of assets denominated in Chinese yuan, which usually would guarantee a higher rate of return.
Previously, investors and speculators who managed to get money into China got a sweet deal. Borrow at very low rates in U.S. dollars, invest the money for a guaranteed 10 percent in China, and don’t worry about defaults (forbidden by policy) and currency risk (pegged to the dollar).
Now the whole risk dynamic has changed. There has been a policy change regarding defaults and the first Chinese companies have defaulted on loans and bonds in 2014 and 2015.
Many of the darlings of international investors in the steel or construction space are suffering from overcapacity, too much debt, and may not be able to repay borrowers in time.
Kaisa Group Holdings Ltd., for example, was the first Chinese developer to default on its U.S. currency debt earlier this year.
The very fact that the first defaults have happened in China, at the beginning of 2014, and the currency is no longer risk-free (August devaluation) scared many investors out of the carry trade and led to the unwind.
For investors, there are two major risk factors in international investing. One is the credit-risk, or the probability the borrower will default, the other one is the currency risk.
Even a 10 percent yield on a relatively safe bond is worthless if the currency you invested in drops 10 percent. China previously did not have currency risk, when the yuan was pegged to the dollar. However, with the surprise devaluation in August (only 2 percent so far), the country signaled it would let the currency drop if necessary.
Most economists think the yuan is overvalued by a good 15 percent. If the currency were to drop by that amount, it would wipe out years of profits for international speculators.
The currency risk also hurts Chinese companies who borrowed heavily in U.S. dollars. They will have to repay their debt with a more expensive currency.
Therefore both speculators and companies are scrambling to get dollars as fast as possible before the situation gets worse.
Ironically, this is leading to the very pressure on the currency which the People’s Bank of China is trying to manage by selling foreign exchange reserves and buying yuan.
“Given the growing uncertainties surrounding China’s growth outlook and currency path, there has already been a slowing in the pace of demand for the yuan carry trade. Any future liquidation may increase the demand for dollars as capital outflows intensify, offshore yuan volatility increases, and the currency weakens,” the analysts wrote.
The recent China Beige Book report of on-the-ground surveys supports this narrative. It states both yields on bank loans and domestic bonds have fallen sharply, indicating domestic monetary easing and a weaker currency.
Of course, China could also just let its currency drop 20 percent and keep the reserves, but it seems it is not quite ready for this kind of free market action.