The Chinese renminbi (yuan) continues to weaken against the US dollar. The direct cause is attributed to foreign investors selling Chinese bonds and capital flight, which could lead to a financial crisis.
A glance at the bar chart shows the US dollar value of foreign investors’ Chinese bond holdings since December 2021. The change in the Chinese currency’s exchange rate against the dollar is superimposed on the blue line.
Most of the Chinese bonds shown on the left scale are corporate and local government bonds issued by real estate development companies and others. Most are denominated in yuan. The exchange rate on the right side of the scale indicates the depreciation of the yuan against the US dollar at the lower end and its appreciation at the higher end.
Chinese bond prices and the value of the yuan have fallen simultaneously since February 2022. In June, foreign holdings of Chinese bonds fell by about $120 billion from January.
A look at what lies behind the trends is instructive.
The geopolitical environment
On February 4, the General Secretary of the Communist Party of China and President of the People’s Republic of China, Xi Jinping, and Russian President Vladimir Putin met at the Winter Olympics in Beijing, where they agreed“The friendship between the two states has no limits, there are no ‘prohibited’ areas of cooperation.
On February 24, Russian troops launched a war of aggression across the Ukrainian border. In response, the United States, Europe and Japan immediately imposed financial and other sanctions against Russia. The United States also informed China that it would apply secondary sanctions if China supported Russia.
In March, the US Federal Reserve (FRB) began to raise interest rates and continued to hike rates in May, June and July.
Impact on Chinese investments
Fear of a second round of sanctions against China and the widening interest rate gap between the United States and China both increase the risk of investing in securities in China, including bonds and bonds. equities, prompting a decline in investment.
The widening of the interest rate differential between the currencies of the two countries will in itself lead to a further weakening of the yuan. Indeed, foreign investors will withdraw their interest as the dollar value of yuan-denominated securities declines with the weaker Chinese currency.
What then is foreign investors’ net investment in Chinese bonds in monthly flow, ie purchases minus sales? The graph is presented as a balance.
According to the Institute of International Finance (IIF) in Washington, values have continued to fall since foreign investors sold $30.7 billion worth of Chinese bonds in March. Through July, total outflows had reached $83.6 billion.
The actions of foreign investors are based on their rational judgment regarding investment returns. It’s safe to assume that big Chinese investors, the majority of whom have vested interests, would agree. Whether they are family members of Chinese Communist Party officials or not, they want to secure profits. If they find it unfavorable to invest their assets in the Chinese market, they will find a loophole in government capital controls and move their assets overseas.
It would be an illegal capital outflow or equity flight to the Chinese system. But what is the magnitude of this output?
Scale of capital flight
According to China’s official statistics, the current account surplus, including trade, in the first half of this year stood at 169 billion US dollars. The People’s Bank of China should have captured this surplus and added it to its foreign exchange reserves. However, its foreign exchange reserves have shrunk by US$179 billion over the same period.
This means that there was a total outflow of US$348 billion. Capital outflows include legitimate outward investments authorized by the authorities. Nevertheless, if we extrapolate from the movements of foreign investors, capital flight should represent a significant part.
What does the exchange rate between the US dollar and the Chinese yuan have in store for us? Lockdowns under China’s zero-tolerance COVID policy may have had an impact. Lockdowns were put in place in Shanghai and other cities in May and June. Economic stagnation due to these actions can have an impact.
War, interest rates and real estate bubbles
There are more important factors. These include the protracted war in Ukraine, the widening interest rate gap between the United States and China due to a further hike in US interest rates and the increased risk of a collapse. of the Chinese real estate bubble.
The Chinese government and the People’s Bank of China have been unable to take fiscal and monetary measures to counter the fall in house prices and the fall in investment in real estate development that has been continuing since the beginning of 2021.
In comparison, the US FRB was able to fight back and avoid a major recession thanks to a massive quantitative expansion of dollar funds after the collapse of Lehman Brothers in September 2008. This collapse was also triggered by the bursting of the housing bubble.
In contrast, China’s unique monetary and financial system makes similar action impossible. The People’s Bank of China would issue additional funds in yuan in response to the magnitude of the increase in foreign exchange reserves, but reserves continued to decline significantly.
Likewise, additional foreign investment in securities in China and a larger external trade surplus are needed to increase foreign exchange reserves. However, foreign investment in China continues to decline. Exports are also unlikely to increase due to the economic slowdown in the United States and other markets.
Nowhere to go
The only remaining option is to devalue the yuan to improve China’s manufacturing advantage. On the other hand, it would further accelerate capital flight and the withdrawal of foreign investment in Chinese securities.
The devaluation of the yuan in the summer of 2015 triggered a spike in capital flight. This time, China could sink further into a financial crisis and a general state of economic turmoil.
According to the August 25 morning edition of The Sankei Shimbun, Honda and other companies have begun to consider moving out of China for their parts supply networks. Given the increasing risk associated with China, the entire industry should rethink its dependence on the Chinese market.
(Read this article in Japanese at this link.)
Author: Hideo Tamura