"None Of The Problems Are Solved" Despite Global "Plunge Protection" Overnight

When many American traders went to bed last night, China was tumbling, the euro was in trouble, and US equity futures were notching lower. Then, as former fund manager Richard Breslow scoffs, it appears the world "reconsidered" and everything rallied to erase any sign of discontent or uncertainty by the time everyone woke up...

Via Bloomberg,

Apparently, the word of the day is “reconsider.”

Across a whole host of assets, we got somewhat violent moves early in the 24-hour trading cycle that managed to unwind themselves over the course of the day.

I kept being told that the euro, Chinese equities, U.S. equity futures, gold, bond yields, Eurostoxx 50, and so on, all reversed their opening, sometimes gap, moves after the market reconsidered what it all meant.

Of course, that’s being a bit too kind. It would be more accurate to say things turned around when traders actually considered things for the first time. But this all matters more than just a collection of knee-jerk reactions that have come to naught as another trading region came in.

 

North America isn’t being asked to break the tie and decide who was right. They are being told that they can afford to ignore the news that propelled things in the first place. After all, we’re right back where we started. No harm, no foul. That would be a mistake, as once again we keep muddling-up short-term and long-term information as if they should be discounted by the same rate and assuming we should trade without benefit of context.

 

 

Chinese equities opened lower leaving gaps from last Friday’s close.

 

 

Big swings: the Shenzhen dropped a quick 2.1% before staging a relentless rally throughout the day to finish up by 0.9%. No leap on the close, just a steady rally.

 

 

The commentary at the lows was as dire as the dismissive tone was at the close.

 

The PBOC proposed additional regulations to curb the run-away shadow banking industry. What was described in the morning as policies that would cause a flood of outflows from various short-term investments were later described as likely to attract foreign inflows. Wait, we’re not collapsing through the last lines of support any more? What a gift -- buy!

 

The message from this is that, once again, the PBOC is delivering on what they have warned about and promised to address. Perhaps instead of trying to deconstruct the “real” Chinese intentions based on outmoded epigrams, we should start to listen to what they’re actually saying. And accept that regulation isn’t bad by definition. Sometimes a healthier Main Street can actually be good for equities--the old-fashioned way. But it would be folly to decide these new regulations must not be all important because of the day’s price action.

 

European shares and the euro were hit early on the German coalition talks collapse.

 

 

What began as “markets are being roiled” quickly turned to markets “shrugged it off.” Hardly. They recovered on the very fortuitously timed announcement that Volkswagen was going to spend an additional EU25B over the next five years on its core brand. That’s hard and good news. May even help out with Germany’s hopelessly flat Phillips curve.

 

 

But don’t think, Chancellor Merkel on her back foot isn’t something with negative possibilities that make it foolish to dismiss. Just hard to enumerate the immediate implications.

As Breslow concludes, the mirage of markets" ignorance does not mean anything is solved.

Some of the other realities to keep factoring into your analysis and avoid being lulled into ignoring include:

• Brexit wasn’t solved because today’s headline was upbeat, it’s serial noise;


• you’ve no way of handicapping Nafta as each debating point is aired;


• no one has a firm handle on the Middle-East;


• and U.S. tax reform may end up just stoking the debate of whether a bad deal is better than no deal.

Don’t ever let someone tell you the really big news is the ones you can afford to ignore

And it appears we"re gonna need more "help"...

Traders Puzzled After Chinese Media Warning Triggers Market Selloff

Overnight we highlighted that despite a massive weekly net liquidity injection by the PBOC (which ended on Friday when the PBOC drained a net 10bn in liquidity) Chinese stocks failed to hold on to Thursday"s gains, and resumed their slump...

 

... headed for their worst week in 7 months.

 

However, it was more than the simply a question of liquidity flows, because it once again appears that Beijing is involved in micromanaging daily stock moves, only unlike the summer of 2015 when China blew a huge stock bubble in a few months, which then promptly burst leaving China scrambling for the next year to figure out how to avoid contagion, this time Xinhua had a different message: sell.

According to Bloomberg, the reason why Chinese stocks - led by Shenzhen shares - slumped on Friday, is due to a warning by state media that one of the nation’s hottest stocks was climbing too fast, which in turn triggered a selloff. And while the SHCOMP closed down 0.5%, the Shenzhen Composite Index closed down more than 2%, with liquor makers and technology companies that had outperformed this year among the biggest losers.

The catalyst that sparked the selloff? China"s biggest liquor maker, Kweichow Moutai, which plunged 3.9% - after tumbling as much as 5.8%, its largest decline since August 2015 - after Xinhua News Agency said its China’s biggest "should rise at a slower pace." Other liquor makers fell in sympathy, Wuliangye Yibin slid as much as 5.3% in Shenzhen, the most since July 2016, and Luzhou Laojiao fell 4.7%, although the stocks, which have more than doubled this year, pared their losses by the close.

In commentary published in the state-owned newspaper, the author said "short-term speculation in Kweichow Moutai shares will hurt value investing and long-term investment will deliver best returns."

The bizarre and unusual critique - traditionally China"s media mouthpieces have only urged stocks to go higher, never lower - capped a week that saw a rout in Chinese sovereign bonds spill into the equity market amid concern about a government deleveraging campaign and faster inflation. For the week, the Shenzhen gauge fell 4.2%, its worst loss since May 2016. The Shanghai benchmark declined 1.5 per cent.

“The Xinhua warning was the last straw,” said Ken Chen, a Shanghai-based analyst with KGI Securities Co. “Expectations of worsening liquidity conditions are also hurting stocks.”

In retrospect, perhaps the Xinhua warning was not so strange: after China"s debt-fueled stock market bubble burst in 2015, wiping out $5 trillion of value, Chinese policy makers have acted to restrain excessive speculation in equities.

“Xinhua is concerned that a runaway rally in a heavyweight like Kweichow will hamper the stability of the overall market,” said Hao Hong, chief strategist at Bocom International Holding Co in Hong Kong.

And while one can wonder why China is suddenly so concerned about even the hint of potential vol spike in the stock market - suggesting that even a modest selloff could have dramatic consequences for the Chinese financial sector - it is certainly strange that whereas even China is acting to restrain the euphoria of its citizens over fears of what happens during the next bubble, in other "developed" countries, the local central bankers, politicians and TV pundits have no problem in forcing retail investors to go all risk assets when the market is at all time highs.

As for China, it will have truly gone a full "180", if in a few months time instead of arresting sellers as it did in the summer of 2015, Beijing throw stock buyers in prison next.

Despite Massive Liquidity Injection, Chinese Stocks, Commodities Head For Worst Week Of Year

The PBOC stepped up cash injections this week, suggesting authorities are trying to shore up financial markets as a selloff in bonds spreads to equities... but it is not working!

As Bloomberg reports, the central bank has already added a net 510 billion yuan ($77 billion) via open-market operations into the financial system this week, matching the third biggest weekly injection this year.

But, it is not enough...

While bonds did stabilize - managing to avoid closing beyind the crucial 4.00% level...

Stocks did not...

As they head of the worst week in 7 months...

And commodities are getting clobbered...

“The increase in cash additions will help soothe market sentiment,” said Qin Han, chief fixed-income analyst at Guotai Junan Securities Co. “But the decline will not be reversed, as the market’s biggest concern is not tight liquidity but tougher financial regulation.”

China: Shadow Bank Inflows Are Critical To Sustain The Ponzi... But They"re Falling

During the Party Congress, even China’s somewhat watered down versus of the free markets was suspended so as not to disturb the glorification of Xi Jinping as the nation’s greatest leader since Mao. Returning to “business as usual”, some commentators have been disturbed by the continued rise in government bond yields with the 10-year hitting 3.93% earlier this week.

Bloomberg described it this morning as a “tumultuous few days”.

We also noted Huachuang Securities Co. comment that bond holders may be about to get hit by “daggers falling from the sky,” if the Party adopts more aggressive deleveraging policies. In a far less sensationalist way, the Wall Street Journal has attempted a post-mortem on the recent sell-off in the Chinese government bond market.

Catching sight of a chain reaction in China’s markets is rare.

 

Carrying out a postmortem of a recent selloff in China’s $9 trillion bond market shows how it is becoming harder for Beijing to untangle its increasingly intertwined financial system. In the aftermath of China’s twice-a-decade party congress last week, yields on benchmark 10-year Chinese government bonds spiked to 3.9%, their highest in three years. Government bond futures fell.

 

Reasons proffered for the sudden rout ranged from expectations of higher U.S. interest rates to general fearmongering.

Having acknowledged the growing complexity of China’s financial system, WSJ provides a valuable insight, noting the relative stability of corporate bond yields during the recent sell-off in the government sector...

An important anomaly to note about the bond rout: as government bonds sold off, yields on less-liquid, unsecured Chinese corporate bonds barely moved.

 

That is atypical in an environment of rising rates - usually, bond investors shed their less-liquid holdings and hold on to assets that are more easily tradable, like government debt.

Using this handy (kind of) diagram of flows in China’s financial system...

...WSJ tries to explain “how the selloff in China really worked”.

In essence what happened is that, as funding costs for Chinese banks have risen, they have been forced to compensate by placing more money in the shadow banking sector, with all the risks that entails (i.e. leverage and risky assets). Here’s the Journal’s version.

Let’s start with the travails of China’s small and midsize lenders that—like most banks—fund themselves by taking in customer deposits and by borrowing in wholesale markets.

 

In China, the latter has increasingly meant issuing short-term bonds known as NCDs, or negotiable certificates of deposit. The trouble for Chinese banks of late is that both these funding sources have become expensive: Borrowing costs have risen as Beijing pursues its deleveraging campaign, while bank-deposit growth has also been slowing.

 

To balance out these rising costs, banks have been placing more of their money with so-called nonbank financial institutions—the likes of trust companies, funds and securities companies—that offer high returns from investing in various markets, from bonds to stocks and commodities.

 

Deposits placed by banks with these nonbanks - the bulwarks of China’s infamous shadow banking system - had grown to more than $4 trillion as of September this year.

Okay, this is where things get more interesting.

Please bear in mind that (as we’ll explain later) a key pillar supporting the stability of China’s financial system is the maintenance of rising flows into the Chinese shadow banks.

This Bloomberg chart shows the rapid growth in China’s shadow banking system in recent years.

The WSJ explains that the reduction in flows into the shadow banks has led to redemptions and something had to be sold quickly...

But with less funds coming into banks now, less can go out. That has led to trouble for the nonbanks, which, after years of only ever-higher inflows, have started facing redemptions.

 

Banks’ claims on nonbanks have dropped 2% since peaking in June, according to Wind Info, equivalent to a $90 billion withdrawal of funds.

 

In addition to these redemptions, the cost for nonbanks of juicing returns on their investments by leveraging up has also risen because of the higher interest rates mentioned above.

 

That brings us to the bond market. Faced with redemptions, nonbanks have needed to sell something, and quickly. Offloading highly liquid government bonds has proven the easiest option.

 

Meanwhile, the nonbanks have held on to their higher-yielding corporate bonds, which at least have the benefit of helping them to maintain high returns.

We think that the Journal’s analysis is correct…but it doesn’t fully appreciate the bigger picture regarding shadow banks’ need to “maintain high returns”.

China’s shadow banks are, in part, engaged in Ponzi schemes, for example in the $4 trillion Wealth Management Products (WMP) sector. In May 2017, Forsea Insurance, one of China’s largest insurers, warned that there would be “mass defaults and social unrest” if it was prevented from selling new WMPs to meet payouts. See “Chinese Insurer Warns Of ‘Mass Defaults, Social Unrest’ Due To ‘Mass Redemption’ Run”.

A month earlier, Minsheng Bank, China’s largest private bank, was found to have committed a RMB 3.0bn fraud by selling non-existent WMPs. See “Investors Rage After 3 Billion Yuan Vanish From China"s Largest Private Bank”.

The sell-off in Chinese government bonds implies that the deleverage in shadow banking we identified in September in beginning to bite.

We are in the last lap of the Chinese Ponzi as, piece by piece, the whole decrepit system is being exposed. In the end, it will boil down to how many trillions of RMB the PBoC needs to print to make the banks and their shadow banking relatives whole.

Kyle Bass: China's $40 Trillion Banking System Has "Largest Imbalances I've Ever Seen"

Kyle Bass’s Hayman Capital has been having a rough year thanks to its widely publicized bet against China’s currency, which has more than reversed its 2016 decline – its largest annual drop since 1994 - as the People’s Bank of China has cracked down on potentially destabilizing capital outflows.

However, Bass – unlike a handful of other former China bears who’ve been forced to scale back, or even reverse, their positions – has said that he is standing by his belief that China’s corporate sector is massively overleveraged, and overdue for a collapse that could destabilize the global economy. Chinese banks, according to Bass, have more than $40 trillion in assets held against $2 trillion in equity.

The dollar’s bull run against the yuan last year helped spark capital outflows as wealthy Chinese worried about the depreciation of their currency. In response, the PBOC tightened restrictions on foreign-exchange transactions for individuals, local companies – quashing a roaring international M&A boom – and even foreign companies, which in some cases have struggled to pull their money out of the world’s second-largest economy.

“So what"s going on right now? Let"s get the elephant out of the room. Let"s talk about China.

Kyle Bass: OK, how much time do we have?

RP: As long as you need. Where are we? What the hell"s going on?

KB: We"re in the such late stages of a game that is the largest global imbalance I"ve ever seen in my life. When you look at on balance sheet and off balance sheets, you look at on balance sheet in the banks, you look in the shadow banks. The number of total credit in the system, China is right at $40 trillion. Think about the number I just said. $40 trillion. And that"s using an exchange rate of call it 6.7 to the dollar, right? So it"s grown 1,000% in a decade. And we"re on a $40 trillion credit system on $2 trillion of equity on maybe $1 trillion of liquid reserves.

RP: Where do you get the equity and liquid reserves from?

KB: Well, it"s the amount of equity in the banks of China. It"s right at about $2 trillion. So that"s kind of a stated number. The reserves is my own calculation, right? The Chinese magically have leveled their reserves out around $3 trillion, which happens to be the minimum level of IMF reserve adequacy as defined by the IMF rule.

RP: So what have they been doing now? So, they were under pressure, and then everything kind of eased off, I guess, as the dollar started weakening a bit.

KB: Yeah. Actually, they"ve done three things. Well, so four things have caused this, quote, easing off that you refer to. Three have been driven by SAFE and the PBOC, one that"s been driven by our illustrious Trump. So the first three are, number one, they essentially halted all cross-border M&A. So if you look at the parabola of M&A coming out of China from 2012 to 2016, it reached dizzying heights in 2016. In 2017, it"s like 15% of the 2016 number and no new deals being announced. Now, they"ll always be some outbound M&A that"s driven by really policy at the Communist Party level, right?

They"ll always buy copper mines in Uganda. They"ll always invest in ports in Greece. They"ll always do things that are from a strategic perspective and a policy perspective. The things that the Communist Party needs to procure resources for its people over the long-term. But when you look at the rampant M&A of money leaving China, they just put a halt to it in November of 2016.

And the second thing they did was they made it impossible for multinational corporations to get their profits and or working capital out of China. And that"s something that has been a problem for a lot of the multinationals that do business in China.”

When asked how he intends to trade China’s inevitable unraveling, Bass said he believes the “ultimate” arbiter of China’s “entire macro situation” is its currency. He intends to remain short, with a target date between November 2017 and June 2018.

“RP: Somebody"s going to be holding that baby in the end, and China"s got the biggest basket in the short dollar issue.

KB: Yeah, but just think, just since January, the dollar index has gone roughly 103 to 92 and change. It"s come in 10% in less than a year. That is an enormous move. And it"s actually pretty beneficial to the US from a trade perspective, right?

RP: Yeah.

KB: Trump figured out very quickly that making America great again doesn"t mean a big, strong dollar. But I think the fourth thing that"s really affected the exchange relationship has been Trump"s inability to get anything done on the Affordable Care Act repeal and replace. Therefore, nothing"s being done on comprehensive tax reform. All we"re hearing now is there"s going to be a tax cut. Well, that"s not going to balance anything. And so his kind of inability to get anything done has also forced the dollar much lower.

RP: So, give us some timings how this plays out. What kind of ways are you looking at? Are you just looking at a currency trade here? Is that the most efficient way of doing this?

KB: That"s it. The ultimate arbiter of the entire macro situation I just described to you is the currency. So that"s where we stay.

RP: And what about a time horizon? I know it"s difficult. I don"t want to pin you down.

KB: Well, no, it actually requires you to pin me down because our investors pin us down.

RP: OK, so when the f***"s this going to happen?

KB: So my best guess is between November and call it June. November 2017, June 2018.”

Foreign multinationals have continued to do business in China despite an array of obstacles, including the Chinese economy’s implicit bias toward state-controlled companies. But now that the Chinese have erected all these barriers preventing multinationals from repatriating profits, Bass expects companies will eventually give up on the “carrot” that is the unrivaled growth potential of the world’s second-largest economy.

“RP: It sounds like they"ve got a temporary fix in place. So what changes the dynamic of that then forces those reserves lower? Because if we"re looking for this whole situation to kind of, you know, the apple carts get upset, how does that happen?

KB: Yeah. What"s interesting to me is, so -  the answer is I"m not sure. I know that in an effort to maintain economic and political stability for the 19th Party Congress, which happens this November 2017, Xi, and Wang, and the ruling elite of China wanted to maintain the stability, needed to maintain it at all costs. And so they"ve tied a knot at the end of their proverbial rope and they"ve been hanging on. But imagine if you"re Qualcomm, Ford, GM, Visa and you can"t get money out of China, you have a US auditor. And so you go through the end of the year, and they"re going to have to rethink how those profits are classified and maybe even how the working capital is classified.
And so it"s my view that they can"t do this forever. And to the extent that a multinational doing business in China is really having severe restrictions on their capital, they"ll just move to Cambodia, or Vietnam, or they"ll move somewhere in the region and start doing business elsewhere.

China wields this economic sword so beautifully. The carrot is so large. The delusion of riches is so great that companies and even investors are willing to suspend disbelief to chase that carrot, and the Chinese know it. And they do a masterful job.”

After highlighting the fact that the real risks to the Chinese economy involve financial stability, President Xi Jinping has begun a crackdown on shady WMP issuance and risky lending in the banks. But as Bass says, “it doesn’t matter who you parachute in to pilot the Titanic after it hit the iceberg.”

“So I think they"re kind of focused on getting through the NPC, and we"ll see what happens.

RP: When is that?

KB: So the way the Chinese electoral system works, it"s every five years. And so that"s this November. So they have kind of a presidential cycle every five years.

RP: And so, I"ve heard this before, is that seems to be a significant date that they just want things to go smoothly, and then they can take some harder measures to try and rectify the economy afterwards.

KB: That"s correct.

RP: And do you get any sense of that within China itself when you talk to people?

KB: You know, they"ve spent a lot of time on trying to get banks to do debt for equity swaps. Xi himself has said the real risk in the economy is financial stability. And really, he"s trying to crack down on excessive WMP issuance and risky lending in the banks. But it"s like, it doesn"t matter who you parachute in to pilot the Titanic after it hit the iceberg. It almost doesn"t matter.

My point is they have some brilliant people at the PBOC. They have some brilliant people in the Communist Party. But we had a lot of brilliant people in the United States that have been running capital markets for over 100 years, and you know how bad we screwed it up. And we only had $17 trillion on balance sheet in the banks, maybe another $5 trillion off balance sheet in an economy $17.5 trillion, and we detonated our banking system. They"ve got four times what we had."

In summary, China’s crackdown on outflows and bad debt were meant to ensure stability ahead of the Communist Party’s quinquennial leadership elections in November. Afterward, Bass expects a certain degree of complacency to develop regarding the economy. The country’s banking system has become too sprawling to control.

The collapse will arrive, Bass assures his listeners. Profiting from it is a matter of getting the timing right – something that’s incredibly difficult for short sellers.

Listen to the rest of the interview below:

Is The Yuan About To Tumble After Friday's Shocking PBOC News? Here Is Goldman's Take

In a move that stunned China currency watchers, late on Friday (local time) Bloomberg reported that China’s central bank decided that it would remove a reserve requirement for financial institutions trading in FX forwards for clients by cutting it to zero from 20% currently. The change would take place on Monday, September 11 (it has yet to be confirmed). As a reminder, banks, funds and other financial institutions trading FX forwards for clients were required from October 2015 to set aside 20% of the past months’ sales as reserves in a move that was aimed at curbing currency speculation. Subsequently, the PBOC further punished traders, or rather shorts, by boosting short-term margin requirements on FX positions, making it virtually impossible to hold on to a short position for a long period of time.

All that changed at the end of last week, when the PBOC effectively "U-turned", and gave a green light to the same FX speculators whom it criticized (remember the Chinese anti-Soros media campaign), slammed, punished, and in some cases arrested, to now short the Yuan once more.

The reason behind the move was simple: in recent weeks the Yuan, both on and offshore, had soared far too high, to the point where Beijing was getting worried about its impact on exporters, as a separate Friday report from Reuters discussed.

On the surface, this was a brilliant solution to Beijing"s problems: it lowers the Yuan on one hand, and on the other, it is not the PBOC who is manipulating the currency, it"s the evil speculators who are "guilty", avoiding being blamed by the US for currency manipulation. Most importantly, the removal of this marginal capital control worked immediately, as the following intraday chart of Friday"s USDCNH clearly showed.  

So will this plan work, and is the Yuan set to plunge in Monday trading? We will find out soon enough, but until then, here is the explanation from Goldman"s MK Tang on what Friday"s move means, and its implications for Yuan policy, but first, here are several analyst opinions, as summarized courtesy of Bloomberg:

CIB Research (Guo Jiayi, Zhang Meng, analysts)

• Scrapping the reserve requirement indicates the PBOC is confident of the yuan’s outlook


• Given the weakening dollar and solid domestic economic environment, it’s unlikely the new rules will bring one-way expectations to exchange rates


• Indicates the PBOC wants to slow yuan appreciation and prevent a herd effect, and it opens the window for further FX regime reforms

Commerzbank (Zhou Hao, emerging-markets economist)

• Policy change underscores that depreciation pressure has largely diminished


• PBOC signals it’s again sitting opposite the market as fresh long CNY positions triggered a rapid appreciation over the past week


• Spread between CNY and CNH forwards to narrow significantly in coming months

Lianxun Securities (Li Qilin, macro researcher)

• PBOC wants to ease strong appreciation trend, which could affect exports


• Chance is limited for the yuan to continue the fast pace of strengthening of the past couple of weeks


• PBOC is likely to show a stronger hand if markets don’t take note

Mizuho Bank (Ken Cheung, strategist)

• Good time to spur hedging demand in both directions in the forwards market


• Institutions which invest in onshore bonds via the Bond Connect can thus hedge FX risks onshore


• Expects USD/CNH one-year forwards to drop, leading to narrower spread between onshore and offshore

ANZ (David Qu, markets economist)

• Change won’t significantly cut corporate FX settlements, which are largely decided by spot prices


• Demand from companies to buy dollar is rather tepid, so any future increase in forward positions should be limited


• New rule will have limited impact on spot market, where central bank “guidance” will play a bigger role


• It’s likely prohibition on net outflows in cross-border RMB pooling will be relaxed or canceled amid yuan strength

Finally, here is Goldman"s extended take:

Reported relaxation of FX hedging cost: backdrop and implications for CNY policy

Chinese media reported late last Friday (though not officially confirmed) that effective Sep 11, the PBOC would cut the reserve requirement on FX derivatives sales to 0% (from 20%), which would reduce the cost of FX hedging by importers.

We see three implications:

1. the authorities may be less concerned about outflow pressures, which appear to have dissipated following earlier episodes of likely intervention-driven CNY strength to counteract bearish sentiment;


2. it marks a possible meaningful step preparing for increased (two-way) CNY volatility in the medium term; and


3. shows the continued importance of tracking signals of policy intention (including the fixing’s “countercyclical factor”) on the near-term CNY path, which seem to point to reduced comfort with the ongoing pace of appreciation.

Main points:

We provide an overview of the FX reserve requirement, and discuss the backdrop for the reported relaxation and the likely implications for the CNY policy.

1. What is the reserve requirement (RR) on FX derivative sales?

Introduced in Sep 2015, the RR sets the amount of FX that each bank has to deposit at the PBOC (with no interest remuneration) in connection with its sales of FX derivatives (including forwards, swaps, etc.) to non-bank customers. The RR has been set at 20% of the notional value of the derivatives.

This is effectively a tariff, increasing the cost for non-bank customers to buy FX via derivatives. Its introduction was in response to strong outflow pressures at that time, part of which was driven by a large amount of FX forwards bought by non-bank customers (worth close to $80bn in August ’15, c. 3x the previous usual amount). The authorities attributed the sizable demand for FX forwards to unhealthy speculation. FX forward purchases have sharply fallen since the RR measure, to less than $20bn in Sep ’15 and less than $10bn in recent months.

Late last Friday (Sep 8), Chinese media (e.g., 21st Century Business Herald) reported that the PBOC would lower the RR to 0% effective Sep 11, although at the time of writing this has not been officially confirmed.

2. What is the recent backdrop for the reported relaxation?

Outflow has significantly slowed since the turn of the year, likely reflecting tighter capital control as well as reduced devaluation concerns. That said, in the first several months of the year, market pressures were still skewed toward net CNY sales. In this context, in May the authorities added a "countercyclical factor" to the CNY fixing mechanism, initially intended to counteract the market’s "herding" behavior that had pressured the currency weaker.

Under the new fixing rule, when the market displayed a CNY-bearish tilt (CNY close weaker than fixing), the countercyclical factor the next day would tend to push CNY fixing stronger, as we have discussed here. But such fixing guidance alone did not seem to be effective. Instead, in late May through early August, we have observed three episodes of sharp appreciation, perhaps driven by policy intervention to entrench the countercyclical factor’s credibility and negate bearish CNY sentiment.

However, more recently since mid-August, the flow pressure seems to have reversed and the CNY strength more market-driven. The August reserve reading, which implies net FX purchase by the PBOC to lean against CNY appreciation, is the first official data suggesting this shift, although we await further flow data for confirmation. The reversal of market forces likely reflects the success of the earlier episodic policy support of the CNY in changing market psychology, as well as a weak USD and better China sentiment.

3. What are the implications for the CNY policy?

The reduction of the reserve requirement on FX forwards to zero would mechanically lower the cost of outflows via derivative transactions. In terms of policy, we see the following three implications:

• The authorities have become a bit less concerned about outflow pressures. Therefore, the RR relaxation could be a precursor for incremental unwinding of other capital control measures, should the flow situation remain benign.


• A meaningful possible step preparing for increased (two-way) volatility in the CNY in the medium term. Besides reflecting higher policy tolerance for outflows, the RR relaxation has the clear effect of lowering the cost for importers to hedge their FX liability exposures. Such hedging would in turn mitigate a main negative side-effect of having a more flexible FX regime, which has long been one of the authorities’ structural policy objectives.


• As for the near-term CNY outlook, while assessing market pressures helps, interpreting policy intention is probably even more important. For instance, reserve data suggests the PBOC bought about $10bn in FX in August, only a moderate amount by China"s historical standards; it could conceivably have bought materially more to limit the CNY appreciation.[1] The fact that it didn"t seems to indicate that the authorities were comfortable with, or even desired, the strong CNY in August.


• There could be “too much of a good thing” more recently, though. We maintain our view that risk of major depreciation is limited in the run-up to the Party Congress (to start on Oct 18). That said, we believe it is useful to continue tracking policy signals for the near-term CNY intention, including the countercyclical factor. Just when bullish changes in the countercyclical factor (i.e., $/CNY fixing below CFETS model-implied) preceded policy efforts to push the currency stronger in May-July, a bearish change in this factor currently could signal a decreased policy comfort with the continued CNY appreciation. On this score, we note that the countercyclical factor in the last few days has turned more reactive to the market appreciation pressures (Exhibit 1), potentially pointing to lower propensity to accommodate much further CNY strength.

Exhibit 1: Countercyclical factor has become more reactive to the previous day’s appreciation, hinting at decreased policy comfort with further CNY strength

A Matter Of "Trust": A Look Inside China's Crackdown Of Its $3 Trillion Shadow Banking Industry

As discussed here in mid-August, when China reported its latest credit data, for the first time in 9 months China"s trillion Shadow Banking Industry - defined as the sum of Trust Loans, Entrusted Loans and Undiscounted Bank Loans - contracted.

These three key components combined resulted in a 64BN yuan drain in credit from China"s economy, the first negative print since October, seen by analysts as more evidence that Beijing’s campaign to contain shadow banking and quash risks to the financial system, is starting to bear fruit.

And, as a follow up report from Reuters overnight details, the crackdown against unregulated shadow financing is accelerating, noting that as the flood of unregulated cash swirls through the Chinese economy, Beijing has been taking aim at the trust companies whose unrestrained lending practices are worrying regulators. The trusts, which as we have discussed previously are at the heart of a vast shadow banking industry, are being pressured to step up compliance and background checks, and are being pushed towards greater transparency.

But the fast-growing 20 trillion yuan ($3 trillion) industry, whose lending operations are cloaked behind opaque structures, will be tough to rein in, according to employees at some trusts.

As Reuters details, a regulatory sanction against one trust, Shanghai International Trust, and a legal case against another, National Trust, offer rare insights into the industry, and reveals just how hard it will be to police it.

Shanghai Trust was fined 200,000 yuan for selling a product that violated leverage rules, according to a regulator’s notice in January. Regulators provided no further details about the case. Under these rules, property developers are only allowed to borrow up to three times their existing net assets. According to two people with direct knowledge of the case, an unknown sum was loaned by China Construction Bank  through Shanghai Trust to Cinda Asset Management Company. Cinda then invested the cash.

One of the sources said Cinda used the cash to acquire land, a sector rife with speculation that regulators have singled out as a “risky” destination for trust company loans. The source provided no further details.

The case against National Trust, which had revenue of 655 million yuan in 2016, involves wealth management products linked to the steel industry. According tot he Reuters reports, the trust was sued in June this year by eight investors who allege it misrepresented the risks involved in products it sold them and failed to adequately assess the guarantor’s creditworthiness. Like most other shadow products that have made news, the trust skirted restrictions on loans to the steel industry by using the products to raise money to lend to a subsidiary of Bohai Steel Group, according to Tang Chunlin, a lawyer at Yingke Law Firm, who is representing the investors.

The plaintiffs invested different sums in the wealth management products, which National Trust promised would deliver an annual return of over 9 percent. National Trust lent the money collected to a Bohai subsidiary, Tianjin Iron and Steel Group Co, according to documents reviewed by Reuters.

Bohai Steel Group, which is undergoing a state-financed restructuring, has liabilities of around 192 billion yuan.

National Trust has now defaulted on the product, according to Tang and Gongyu Zhou, one of the eight investors, because Tianjin Iron and Steel is unable to pay back its loan.The products were also illegally sold via third-party non-financial institutions, Tang and Zhou said.

In his complaint, Zhou said he invested one million yuan in the product over two years from 2015 through 360caifu.com, an online finance platform. And now that the government has not bailed him out, he is angry.

He also may have to wait a long time before he recovers even a fraction of his investment: despite its eagerness to crack down on shadow debt, the biggest challenge facing regulators is that many trusts employ a baffling array of structures, and funnel money through complex webs of beneficiaries, which makes untangling transactions extremely difficult.

Nine people working at trusts, including the two with knowledge of the Shanghai Trust case, said such complex structures were often deliberately used to sidestep lending restrictions on banks and borrowers.

“Really, only the project manager knows exactly how the money flows,” said a senior employee at one trust firm. The source and others at the trust firms could not be named because they were not allowed to speak to the public.

The shady, no pun intended, practices of the trusts, and the speed at which the industry is growing, have made them a target for Beijing as it tries to keep a lid on risky lending, cool overheated markets and control corporate debt. In April, Deng Zhiyi, head of the CBRC’s trust department, warned of “severe risks” from funds flowing into the real estate, coal and steel sectors through trusts.

The unregulated industry is now roughly a tenth the size of China’s commercial banking sector, and is one of the biggest sources of funding as the following Bloomberg chart shows.

While the companies are overseen by China"s financial regulator, the CBRC, they are not held to the same standards as banks. For example, they do not have to meet the same capital adequacy standards. However, as we reported at the time, the CBRC set out in detail in April certain structures that the trusts should not use, such as money-pooling schemes and structuring products to avoid restrictions on leverage.

That was “a signal for financial institutions that from a legal and enforcement perspective, we are entering a stricter period,” said Armstrong Chen, financial compliance partner at King & Wood Mallesons.

Trust firms will also have to start registering the details of their products, identifying the ultimate borrower of funds, this year, said Chen, who is in regular contact with the regulators.

Chen said the requirement would improve transparency, but people at trust firms say it will still be difficult to detect the use of the under-the-table agreements typical of the industry.

The Shanghai Trust case also reflected the tougher line being taken by regulators. The fine would have been negligible for the state-owned company, one of the largest trusts with a total of 3.89 billion yuan in revenue at the end of 2016. But, like in the case of Beijing"s crackdown on China"s major money-laundering conglomerates like Anbang and HNA, three Reuters sources said that Shanghai Trust was also barred from selling products to insurers for three years, a blow to a company that had made considerable sums selling products to the sector in recent years. One insurer invested as much as 10 billion yuan in just one of its property projects, according to one of the sources.

In any case, should Beijing be successful, the supply - and demand - for Trusts will plunge, as they take on more of the characteristics of China"s conventional loans offered by banks.

To be sure, some of the trusts are already responding to the government pressure. Anxin Trust is increasing the number of onsite visits by staff and has doubled its compliance team, a Reuters source said. The trust is also looking at less risky deals – in healthcare, for example, rather than the more volatile property sector.

Despite these changes, the government’s job managing the trusts keeps growing. In the first half of this year, trust loans increased by 1.31 trillion yuan, which compared with 279.2 billion in the period last year, according to central bank figures.

That growth will be a challenge for the regulator, which is already facing staff shortages as it struggles to keep up with a broader official crackdown on financial risk.

Meanwhile, the trusts see more boom times ahead: "the demand for trust loans is increasing," an internal report at a large trust firm in May said. “In the past, state-owned-enterprises would not consider such loans, but are now considering them,” according to the non-public report which was made available to Reuters on the condition the name of the company was not disclosed. 

* * *

Finally, even if China manages to crackdown on Shadow Banking there is another problem: as a recent report by Natixis put it perfectly, "when one [credit] door closes [in China], another one opens up." This simply means that as Beijing slams the door shut on Trust and other key shadow debt components, these will be offset by an increased usage in others such as WMPs, NBFIs, Repos, Negotiatable Certificates of Deposit, and money markets. Below are the highlights from the report:

As deleverage becomes a higher level objective (but sometimes conflicting) to the Chinese leadership, banks now face more restrictions from regulators. In any event, this is not the first time they find themselves in the regulatory whirlpool. From the usage of repo agreements to wealth management products (WMPs), and most recently negotiable certificate of deposits (NCDs), banks have been very creative in playing the cat and mouse game in front of evolving regulations.

Flourishing financial innovation has helped China’s leverage process to continue unabated. The deleveraging process has hardly begun. In contrast, liquidity seems to be increasingly scarce, which keeps on lifting the cost of funding. In fact, overnight SHIBOR is at record high since the difficult events in 2015, very close to 3% (Chart 1). One of the key reasons for the liquidity shortage is related to tighter regulatory control from the People"s Bank of China (PBoC), in particular stricter Macro Prudential Assessment (MPA). This has hampered the use of WMPs to fund banks’ asset growth. They have already shrunk by 1.6 RMB trillion to 28.4 RMB trillion in May 2017 (Chart 2).

After the PBoC limited the use of WMPs, there are now also more regulations targeted at NCDs, which are short-term, non-collateralized paper with an even higher funding cost than the SHIBOR. This has led to a fall in issuance, but has grown again since June 2017. The underlying reasons could probably be a lack of other options and the regulations are not as tight as they may appear on the surface. In fact, the PBoC’s pressure affects banks very differently. It penalizes banks short of liquidity and benefits those long of liquidity. This simply means that China’s five largest commercial banks (all state-owned) are the winners while the others are the losers.

As liquidity is increasingly expensive, liquidity scarce banks have also developed new ways to bypass regulations through money market funds (MMFs), which have reached 5.86 RMB trillion in a very short period of time. The quick pace of expansion may pose extra liquidity risks especially when three-quarter of the assets have a maturity less than 90 days.

Beyond the – probably unintended – push for financial innovation, the PBoC’s regulatory move is also pushing further the duality of China’s banking system. When small banks are struggling for liquidity, large banks stand to benefit from the regulatory crackdown. The latest 2017 Q2 results have confirmed our expectations that large banks can gain from regulatory arbitrage and risks are rising for smaller banks. In other words, the improvement in bank results is not only due to better economic conditions but also to regulatory arbitrage.

The full Natixis report on why Beijing is unlikely to ever be able to get full control of its non-traditional credit creation can be found at the following link.

China PMIs Unexpectedly Accelerate Despite Ongoing Employment Contraction

Validating the recent surge in iron ore, which has jumped more than 18% from 2017 lows hit just two weeks ago on speculation the PBOC may be willing to flirt with another round of inflation, overnight Beijing reported an unexpectedly strong bounce in its manufacturing and service sectors. 

China’s NBS June manufacturing PMI came in at 51.7 for June, above both the previous reading of 51.2 and expectations of a 51 print, remaining comfortably above the 50-point expansion line. This was the second highest level of 2017, on the back of improving market sentiment and industrial upgrading, according to an NBS statement posted on its website, despite an ongoing troubling contraction in the employment subindex. Unlike the Caixin PMI, the official index tracks mostly larger, state-owned enterprises.

Two key sub-indices both increased from the previous month, although ominously the employment index declined for one more month and remained in contraction territory:

• The production sub-index went up to 54.4 in June, higher than 53.4 in May.


• The new order sub-index also increased to 53.1 in June from 52.3 in May.


• The employment index slightly declined to 49.0 in June, from 49.4 in May.

Both inflation indicators were higher, as the input prices index rose to 50.4 from 49.5 in May, and the output price index rebounded to 49.1 from 47.6 in May after three consecutive months of decline. Trade indicators were stronger: Both the new export order index and the import index increased by more than 1.0 pt, reaching 52.0 and 51.2 respectively. Raw material inventory inched up (to 48.6 vs. 48.5 in May) but finished goods inventory declined (to 46.3 vs. 46.6 in May). The suppliers" delivery times suggested longer delivery times (which imply better demand conditions) - it fell for a third consecutive month in June, from 50.2 in May to 49.9.

"Stronger foreign demand is helping to support manufacturing activity," Capital Economics" Julian Evans-Pritchard wrote. "The price components both increased for the first time since December, suggesting that downward pressure on producer prices may now be easing."

Separately, the official non-manufacturing PMI (comprised of the service and construction sectors at roughly 80%/20% weights) also surprised to the upside, rising to 54.9 in June from 54.5 in May. Services PMI rose to 53.8 from 53.5 in May, while construction PMI climbed to 61.4 from 60.4 in May.

The stronger than expected numbers "mean that momentum in the economy continues to be robust and we’ll have only a gradual slowdown at worst in the coming quarters," Dariusz Kowalczyk of Credit Agricole in Hong Kong, said in a Bloomberg Television interview. "China is doing very well."

As Bloomberg notes, economic activity this year has so far proven more resilient than expected - likely on the heels of the loan explosion at the start of the year which has since been tapered alongside China"s shadow banking crunch - giving policy makers time to focus on reining in financial risks and cooling a frothy property sector. Firmer global trade is boosting corporate profits and hiring, easing fears - for now - that efforts to cut excessive financial borrowing could derail the government’s target of 6.5% expansion in output.

Companies are assuming that curbs on excess leverage and the property sector will be transient this year, as the Communist Party won’t allow much economic pain before the leadership transition in the fall, according to a report published by research firm CBB International this week.

Goldman adds that judging from the NBS PMIs, June activity growth appeared to be healthy, however it adds that one caveat is that China’s mfg PMI trends seem to be at least slightly distorted by prices - thus the increase in output prices in June might have flattered somewhat the pickup in the headline PMI reading.

The Caixin manufacturing PMI release next Monday will give another early gauge of activity momentum in June.

Yuan Funding Costs Spike As China Changes FX Rules

The effects of China"s rules-change proposals around the Yuan Fix are already starting to show in the FX, money markets as one-week funding costs have exploded to the annualized equivalent of 14%...

As a reminder, we reported late last week that China announced it would introduce a new "counter-cyclical factor" to reduce exchange-rate volatility while undermining efforts to increase the role of market forces. In some ways this announcement was not unexpected: recall that after a period of eerie stability, on Thursday the Yuan surged shortly after China"s downgrade by Moody"s, which prompted speculation that the central bank was directly manipulating the currency as the PBOC’s daily fixings had "materially diverged" from the prescribed formula, resulting in a gap between the reference rate and currency’s spot value.

Roughly at the same time as a similar move was taking place on Friday, Bloomberg first reported and China later confirmed that policy makers would add a “counter-cyclical factor” to the yuan’s daily fixing, a move which "would give authorities more control over the fixing and restrain the influence of market pricing." Subsequent detailed revealed that authorities would change the daily $/CNY fixing mechanism, so that the change of the fixing from the previous day’s close would also take into account a “counter-cyclical  adjustment factor” (how this is determined is not specified though), in addition to the USD’s movement against a basket of currencies.

While the practical consequence was a surge in both the onshore and offshore Yuan to three month highs, traders and commentators were left confused by this latest intervention by Beijing into what has become China"s fulcrum security.

“The counter-cyclical adjustment factor sounds like an increased role for the fixing to be nudged away from where markets would set it,” Sean Callow of Westpac Banking Corp told Bloomberg. “The authorities’ actions give the impression that they are more worried about yuan stability than declared in their public statements.”

The reaction has been notable...

Offshore Yuan has spiked dramatically in the last few days - coinciding with apparent Fed dovishness in the minutes and PBOC rule changes...

And, as Bloomberg details, deliverable yuan funding costs have soared after the PBOC said it’s considering changing the way it calculates the yuan daily reference rate. One-week forward points have more than doubled to the equivalent of about a 14 percent annualized interest rate.

Though traders anticipate that funding costs will retreat after month-end, a policy shift may keep markets on edge -- on two previous occasions the PBOC adjusted its fixing mechanism, in 2015 and earlier in 2017, costs remained elevated for weeks.

China Resorts To “Old School” Tactics To Support Inflows

Submitted by Gordon Johnson of Axiom

Is the PBoC “Tweaking” the FX Reserve Data to Improperly Show Foreign Inflows?

Over the past 30 months when the PBoC sold/brought dollars (evidenced by a m/m decline in PBoC funds outstanding for FX), 66.7% of the time reported FX reserves fell/rose.

Yet, in each of the past three months this year when data is available (Jan./Feb./Mar.), this trend has not held up. In fact, in Feb., despite the PBoC selling $6.26bn worth of dollars, which implies FX reserves should have fallen by a similar amount, reported FX reserves by the PBoC actually gained $6.92bn; and in Mar., despite $15.85bn in dollars sold, the PBoC reported FX reserves gained $3.97bn (thus, painting a “rosy” picture of foreign capital flowing into the country).

So how is this possible?

Well, the likely explanation centers on the PBoC likely rolling (i.e., selling) a number of dated long-term US treasury bills that were comfortably in the money, allowing for profits which were subsequently used to “pad” the FX reserve balance figure.

Why would the PBoC do this? In short, it makes it look as if money is actually flowing back into China, potentially encouraging those thinking of offshoring capital to keep the money inside China.

Vancouver House For Sale: Only 2,099 Bitcoin

In February 2016 we explained, correctly in retrospect, that the reason behind the unprecedented surge in Vancouver home prices was the seemingly constant flood of "hot Chinese money" desperate to park itself as far away from China"s banking system, and into offshore real-estate. This is how we laid out the stylized sequence of events that culminated with Vancouver home prices surging by over 20%:

1. Chinese investors smuggled out millions in embezzled cash, hot money or perfectly legal funds, bypassing the $50,000/year limit in legal capital outflows.


2. They make "all cash" purchases, usually sight unseen, using third parties intermediaries to preserve their anonymity, or directly in person, in cities like Vancouver, New York, London or San Francisco.


3. The house becomes a new "Swiss bank account", providing the promise of an anonymous store of value and retaining the cash equivalent value of the original capital outflow.


4. Then the owners disappear, never to be heard from or seen again.

Separately, in mid-2015, when bitcoin was still trading in the low $200s, we also predicted that in an attempt to bypass China"s increasingly more draconian capital controls, Chinese oligarchs and ordinary savers would increasingly turn to what at the time was a largely unregulated medium of exchange: bitcoin.

we would not be surprised to see another push higher in the value of bitcoin: it was earlier this summer when the digital currency, which can bypass capital controls and national borders with the click of a button, surged on Grexit concerns and fears a Drachma return would crush the savings of an entire nation. Since then, BTC has dropped (in no small part as a result of the previously documented "forking" with Bitcoin XT), however if a few hundred million Chinese decide that the time has come to use bitcoin as the capital controls bypassing currency of choice, and decide to invest even a tiny fraction of the $22 trillion in Chinese deposits in bitcoin (whose total market cap at last check was just over $3 billion), sit back and watch as we witness the second coming of the bitcoin bubble, one which could make the previous all time highs in the digital currency, seems like a low print.

With one bitcoin now going for roughly $1,800 - and with the PBOC repeatedly cracking down on all forms of bitcoin cross-border flow - this prediction also turned out to be right.

So putting the two together, at least one enterprising Canadian homeowner has decided to make life for potential Chinese buyers especially easy, and in a posting on the Hong Kong edition of Craigslist, has listed a relatively modest Vancouver house for the price of 2,099 bitcoin.

Bitcoin New House for sale 2099 btc (Vancouver,Canada)

Brand new house for sale in Vancouver, British Columbia, Canada. One of the hottest markets on the planet,Voted #1 place to live in the world. Bitcoin and Ethereal accepted.2099 btc.

For more information please respond to Ad. The house is located in Coquitlam.

At today"s exchange rate of US$1,737 for one bitcoin, the US dollar equivalent price is roughly $3.6 million or C$4.9 million. So what does nearly five million Canadian dollars buy enterprising Chinese investors who are willing to pay up for the convenience of bypassing currency conversion into Canadian dollars altogether? This:

Citi Urges "Caution Ahead": Four Major Chinese Indicators Are "Staring To Wave Red Flags"

Another day, another warnings about China"s fading credit impulse (see here in February, and Pimco most recently), and market complacency about what the recent monetary tightening and drop in commodity prices in Chinese markets means for global markets, this time from Citigroup.

In the latest note from Citi"s cross-asset strategist, Jeremy Hale, titled simply enough "China: Caution Ahead", he highlights the long-standing trend lower in the EMRA, or Emerging Markets Risk Aversion Index (CIGMEMRA Index on Bloomberg) which is Citi"s measure of aggregate risk aversion in developing countries, which in turn has led many investors to ask the bank whether "investors are getting complacent on EM."

While Hale fails to answer directly, he does point out that while forward returns are mixed across the asset classes, "risky assets don’t usually fare that well when EMRA is low."

In this context, China is key, and much of the peace of mind for investors has been based upon broad sympathy with the view that 2017 will be mainly a year of “steady boat” economic policy from the Chinese Authorities as we head into the 19th Party Congress this autumn.

Hale notes that one potential factor that could threaten the "steady as she goes" status quo is the informal rule that China"s leaders retire if they have reached the age of 68 when the congress takes place. If President Xi has the clout to get the age limit  waived (not to yet be assumed) then the Xi-Wang duo could continue to run China for another five years, if not longer. As such, heading into the plenum, stability has been an EM positive.

Politics and the 19th Congress aside, Citi notes that certain, more mundane Chinese macro indicators "are starting to wave red flags", among which:

• The Markit PMI is starting to turn over


• China"s Inflation Surprise Index - a leading indicator to global inflation metric - has posted a recent sharp drop


• China"s import trade has likewise tumbled after surging recently


• Chinese Iron Ore imports into Qingado port have plunged

These are shown below:

Adding another "red flag", Hale also notes that "some market commentators in recent weeks have highlighted that perhaps there is a major risk that consensus opinion is again overlooking the influence of China’s credit cycles, and thus perhaps overstating the potential contribution of future Chinese demand growth to the global outlook (Figure 4). And Citi’s EM strategists think that the recent macro-prudential tightening in China could possibly contribute to more negative spillovers in the coming months."

While we have repreatedly demonstrated various iterations of this all important Chinese "credit impulse" in the past, the following chart of the 12M change in China"s credit impulse, this time as created by Citi, deserves to be seen again:

As a result, in order to assess the changes to the monetary backdrop in China, Citi’s China economists have created their very own Monetary Conditions Index (MCI, higher = looser monetary conditions, Figure 5). The Citi China MCI is calculated by using the weighted average of lending rates, M2 growth, and the REER. Interestingly, their caveat to just using a more mainstream credit cycle chart (like the  Bloomberg one above) is that there are places where the credit growth deviates from indicators such as the PMI. Moreover, China’s credit system has gradually been moving from a bank loan denominated system to a more diversified financing model (Figure 5, bottom RHS).

The most obvious observation in the chart above is the clear effect of the recent 2015 stimulus. "The MCI index rose sharply from all-time lows, but since November last year this has turned. Four consecutive months of declines in this MCI suggest liquidity conditions are starting to tighten."

Next question: What happens if this tightening continues?

To assess the historical impact of declines in the MCI and thus perhaps forecast as to what may be witnessed in coming quarters, Citi takes 4 previous turning points in the China MCI and then plot what materializes in each cycle and on average in the 24 months post local peak in the MCI.

Citi"s bottom line is hardly a surprise: 

"as we witness a turn to tighter monetary conditions, this tends to be quite bearish for the hard data as we show above (Figure 6). Across the board, on average, these charts suggest material downside risks to YoY growth in measures of domestic activity."

Hale then breaks down the impact of China"s slowdown across various asset classes, as follows:

• Broad FX: On average, both aggregate G10 and EM FX tend to soften around -6% vs the USD, within the first 9 months after a turn in the MCI, although different cycles vary to some degree thereafter.


• Rates: 10y UST yields on average tend to move sideways initially as the reflationary momentum fades. Around 8 months after the MCI turns, history shows that the 10y UST yields fall. Breaking this into its real and breakeven constituents shows the repricing lower in 10y breakevens is most evident (~- 40bps on average in 9 months), as likely disinflationary forces kick in from slowing demand growth. On average, curve implications are biased towards substantial flattening (on average ~20bps in 9 months) as the implication takes grip on the global outlook.


• Equities: Risky assets in EM (local) broadly hold up well until suffering on average a soft patch at around 5-6 months, seeing around a 5% correction in local terms.


• Credit: Here, risks to wider EM spreads are worth highlighting. Current CDX EM spread levels may be too tight by a significant magnitude. Widening of EM corporate spreads is evident in every historical period. Similarly in sovereign space, China CDS on average widens in the first 6 months after loose conditions peak. Both these historical developments are important for trades in our macro portfolio, as we discuss later.


• Commodities: Broader effects quite limited (Figure 11). More China centric commodities see downside risks mainly between 6-9m after the turn in the MCI. Given that’s where we are in the current period, the recent slides in copper and iron ore may not be surprising therefore. Any relationship to gold prices isn’t wholly evident

The next question is should China slow, what - if anything - can the PBOC still do?

If this MCI tightening persists and macro data follow, how can the PBoC react?

More recently, as we have written before, China has focused more on fiscal policy and the RRR, rather than policy rate cuts (Figure 12, LHS). One reason for this is that the PBoC is probably cognisant that they are reaching their “zero bound” and that the room to maneuver in a crisis is becoming limited. As such they are likely preserving some fire power. Indeed, note how the current easing cycle has been much less aggressive (in magnitude and from a time perspective) than in some historic episodes (Figure 12, bottom, middle).

As an aside, what this means is that China now has, by far, the highest real policy rates amongst the largest economies (they actually moved into positive territory again). Together with a still very rich  currency, this exacerbates the headwinds for the domestic economy long term. Our hunch is that the PBoC will likely continue using the RRR to manage liquidity – and this is also our economists’ base case. And probably only in a sharper downturn are they likely to resort to policy rates cuts.

* * *

Hale"s takeaway is predictable: "tighter monetary conditions in China, if sustained, may mean that the period of unexpectedly strong Chinese activity growth, which started in 2016 Q1, is coming to an end."

Despite continuing to use higher money-market rates to discourage leverage, the PBoC have enough in their toolkit to ease liquidity conditions if needed. But investors should be warned that volatility may not be contained till the end of the autumn. Historically, on average, EM risk aversion has risen from this point in the MCI cycle (Figure 13).

While the jury is still out (crashing commodities notwithstanding) whether China has indeed turned the monetary corner, Hale admits that "the implications for sovereign CDS are clearly negative and thus widening China CDS is one way to hedge portfolios/trade this theme.

Citi"s big picture conclusion is actually hardly a surprise, as it recaps what we have said and shown before: China"s reflationary spark is fading, and it will now be up to Trump to provide the next global impetus for economic recovery.

Admittedly, China’s contribution to the broader global recovery may be waning. Further legs to the global reflation theme may now rely even more so on the Trump administration’s ability to deliver on key campaign promises.

As discussed in previous Weekly’s, we continue to hold an outright tactical long in 10y UST futures (with a stop on the 10y generic yield at 2.45%), which likely has a high delta to the data momentum that are showing signs of decline from post GFC cyclical highs. We continue to favour our 5s10s $ flattener too, which should also perform should China growth slowdown or Trump delay on tax reform/ fiscal stimulus.

Finally, to all those who still harbor hope that the current administration has a chance of passing any laws that boost the US economy, it may be a good idea to hedge "just in case" - at least volatility is record low across all asset classes...