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Is The Market Being Deceived About The Pace Of Capital Outflows From China?

If you needed any proof that it is now all about China when it comes to the narrative that’s driving global capital markets you needn’t look much further than last month’s Fed decision. 

The FOMC’s “new” (and by “new” we just mean that they have finally admitted to the reflexive nature of their job in the post-crisis world) reaction function has been characterized as a tacit acknowledgement that the Eccles cabal is now “market dependent”, but in reality, they’re simply “Beijing dependent” because at the end of the day, this is all driven by what happens in China. 

Of course no data point emanating from the East is more important than that which shows just how quickly the PBoC’s stash of USD reserves is falling in the face of continued pressure on the yuan.

We won’t endeavor to recount the whole story here as we’ve documented it exhaustively over and over again since August 11 (a day that will live in infamy for FX traders), but the gist of it is simply that while China may indeed be planning on implementing a double-digit deval, it needs to be "controlled" (i.e. on Beijing’s terms) and so, expectations must be managed and that means dumping USTs by the hundreds of billions in order to prop up the yuan over the course of the transition.

This effort has added two spinning plates to Beijing’s collection: 1) onshore FX intervention, 2) offshore FX intervention, but as we've noted quite a few times of late, if one doesn't know what to look for, it would be easy to believe that the pace of the Chinese FX reserve burn is slowing but that - much like believing that because Copom uses swaps to protect the BRL there are no capital outflows in Brazil - would be a grave mistake. It’s with that in mind that we bring you the following rundown of the latest Chinese FX reserve data courtesy of the "smartest" guys in the room.

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From Goldman

Bottom line:

PBOC’s FX reserves decreased by US$43bn from US$3.557tn at end-August to US$3.514tn at end-September (vs. $94bn FXreserve fall in August), suggesting a slowdown in FX outflow. Nevertheless, additional SAFE and PBOC data, due to be released in the next two weeks, should also be useful to gauge FX flows.

Main points:

The People’s Bank of China (PBOC) reported that its foreign exchange reserves dropped by US$43bn in September (vs. $94bn fall in August), to US$3.514tn at the end of the month.

It is possible to get an approximate sense of the valuation effects stemming from currency movement: e.g., assuming the currency composition of the PBOC’s FX reserves broadly follows that of the average country’s (using the IMF COFER weights, which suggest roughly 70% in USD for EM countries), the currency valuation effect would probably be negative to the tune of roughly US$5bn (i.e., excluding currency valuation effects, sales of FX reserves might have been about $38bn based on today’s data). Today’s data suggest that the FX outflow situation moderated in September amid clearer policy signals to support the currency and macro-prudential restrictions to slow outflow.

Nevertheless, it is not straightforward to derive the actual FX-RMB conversion trend from headline FX reserves data. Besides currency movements, there could also be significant valuation effects from changes to the market prices of the PBOC’s investment portfolios, and those effects are hard to estimate given the uncertain asset composition. Moreover, there could also be possible short-term transactions and agreements between the PBOC and banks (e.g., forward transactions, FX entrusted loan drawdown or repayment) that may complicate the interpretation of the change in FX reserves.

In our view, a preferred gauge of FX-RMB conversion trend amongst onshore non-banks would be SAFE data on banks’ FX settlement on behalf of their onshore clients (to be out on October 22nd). That report captures banks' FX transactions vis-à-vis non-banks through both spot and forward transactions (for August this data showed an FX outflow of $178bn). But to assess the overall FX-RMB trend, including in the offshore RMB (CNH) market, other FX data sets such as the position for FX purchase would be useful supplements—these are not affected by valuation effects and include FX settlement between the onshore banking system and offshore banks, although they do not account for forward transactions. Data on the position for FX purchase covering the PBOC should be out on October 14, and similar data covering the whole onshore banking system (PBOC plus banks) should be released at around the same date, although this is not completely clear.

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The point is that, as Goldman noted last month, we need to take account not only of the PBoC's non-spot market intervention efforts in the offshore market, but also of banks' forward books if we want to get a better read on capital outflows in China. 

In short, the headline figure from September probably isn't even close to reality, because as we documented a few weeks back, China had spent more than the reported $43 billion in the first two weeks of September alone and even that figure was probably far too low because banks appear to be using their own forward books to absorb some of the outflows.

The takeaway is that to the extent the overnight relief rally in the ringgit and then subsequently in other Asia EM "assets" was catalyzed by a "better" than expected read on the situation in China, the market may be making a mistake because just like Chinese GDP prints, the headline figure on the PBoC's store of FX reserves should be taken with a grain (or perhaps a whole shaker) of salt when it comes to drawing conclusions about the pace of outflows from the world's second most important economy.