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"We Do Not Think This Is Sustainable": Barclays Warns On Massive Cost Of China's FX Intervention

One of the most important things to understand about China’s doomed attempt to simultaneously manage the stock market, the economy, a deleveraging in some sectors, a re-leveraging in others, and the yuan is that it’s bound to produce all manner of conflicting directives and policies that trip over each other at nearly every turn. One rather poignant example of this is the attempt to rein in shadow lending without choking off credit growth. Another - and the one that will invariably receive the most attention going forward - is the push and pull on money markets by the PBoC’s FX intervention and offsetting liquidity injections. 

Recall that Beijing’s open FX ops in support of the yuan necessitate the drawdown of the country’s vast store of USD reserves. In other words, they’re selling USTs. The effect this historic liquidation of US paper will have on global liquidity, core yields, and Fed policy has become the subject of fierce debate lately although, as we’ve been at pains to make clear, this is really just a continuation of the USD asset dumping that was foretold nearly a year ago when Saudi Arabia killed the petrodollar.

In any event, when China liquidates its reserves, it sucks liquidity out of the system. That works at cross purposes with the four RRR cuts the PBoC has implemented so far this year. In short, Beijing, in a desperate attempt to boost lending and invigorate the decelerating economy, has resorted to multiple policy rate cuts, but to whatever degree those cuts freed up banks to lend, the near daily FX interventions undertaken after the August 11 deval effectively offset the unlocked liquidity. 

What this means is that each successive round of FX intervention must be accompanied by an offsetting RRR cut lest managing the yuan should end up completely negating the PBoC’s attempts to use policy rates to boost the economy - or worse, producing a net tightening. What should be obvious here is that this is a race to the bottom on two fronts. That is, the more you intervene in the FX market the more depleted your reserves and the more you must cut RRR until eventually, both your USD assets and your capacity to deploy policy rate cuts are exhausted. There are only two ways to head off this eventuality i) move to a true free float, or ii) implement a variety of short- and medium-term lending ops to offset the tightening effect of FX interventions in the hope of forestalling further RRR cuts. Clearly, this is a spinning plate if there ever was one, as attempting to figure out exactly what the right mix of RRR cuts and band-aid reverse repos is to offset FX interventions is well nigh impossible. It’s against this backdrop that Barclays is out with what looks like one of the more cogent attempts yet to outline and illustrate the above and explain why it simply isn't sustainable. Below, find some notable excerpts. 

First, here’s Barclays explaining what we’ve said for weeks and what BNP recently highlighted as well, namely that while the PBoC used to manipulate the fix to control the spot, it now simply manipulates the spot to control the fix, which in fact leads to less of a role for the market, not more:

Since China’s FX policy change on 11 August, spot CNY has traded close to the daily fixings. However, this apparent success may have come at a heavy cost. While the daily USDCNY fixings are more aligned to the previous day’s close, the close itself appears not to fully reflect market forces.

Of course less of a role for markets means more of a role for the PBoC, and that means FX reserve liquidation. There’s been no shortage of attempts to quantify the burn rate, but for what it’s worth, here’s Barclays estimate:

Our analysis suggests that the PBoC stepped up its FX intervention to USD122bn in August, from ~USD50bn in July, which underscores the significant pressure from capital outflows. Nonetheless, this suggests that the recent relative stability of spot USDCNY could be misleading. Based on the available data for FX intervention in July and our estimates for August, the PBoC has spent around USD172bn on intervention in both July and August. While the PBoC has huge FX reserves (USD3.65trn as of July 2015), if the current level of capital outflow pressures is sustained, we believe this currency defence could become costly. If the pace of FX intervention remains at USD86bn per month, we estimate that the PBoC could lose up to USD510bn of its reserves between June and December 2015, which would represent a nonnegligible decline of 14%.


As should be clear from everything said above, FX interventions and liquidity injections are, as Barclays puts it, simply two sides of the same coin, and to the extent the interventions continue, so too will the liquidity ops. Here’s an in-depth look:

So what's the solution? Well, there isn't one. As Barclays concludes, until expectations of further yuan weakness subside, the situation can't stabilize: "We do not think the present policy is sustainable given the associated costs in terms of FX reserves depletion and liquidity imbalances [and] as such, we maintain our view that the CNY will need to depreciate further to stabilise capital outflows; we forecast a further 7% fall by year-end."

So unless suddenly everything is fixed or, as SocGen puts it, "for the RMB to appreciate compared to its current value will require a very positive environment for EM coupled with a cessation of capital outflows and a vibrant cyclical growth and an export recovery," the road ahead looks rather precarious, and not just for China, but for the Fed and by extension for the entire global economy. And on that note, we'll close with what we said earlier this week:

As the Fed debates whether or not to hike, and how much, the acceleration in Chinese capital outflows starting on August 11 has set the path for the Fed, and at this point any incremental delay in hiking merely adds more to the already vast cross-capital and currency confusion around the globe. However, no longer is the Fed's quandary open ended: with every passing day, China is suffering incremental tens of billions in capital flight and reserve liquidation, and thus, tighter global financial conditions, as can be expected from the unwind of the world's largest depository of USD-denominated reserves.


Finally, what all of this really means, is that having pushed China to the point of dissociating itself from the USD peg officially, the more the Fed tightens, the more China will have to push back through devaluation or otherwise, and the more capital outflows it will be subject to, thereby amplifying the Fed's tightening posture around the globe. In this very unstable arrangement, suddenly the smallest policy error will reverberate exponentially, and result in the only possible outcome: the Fed's admission of policy failure by adopting a tightening bias, and ultimately launching another phase of monetary easing, be it QE4 or perhaps even the long-overdue and much anticipated Friedmanesque "helicopter money" episode.