As Russia braces for further sanctions from Washington D.C. over their alleged role in "meddling" in the 2016 U.S. election, they are reportedly prepping a $1 billion yuan-denominated bond issuance in an effort to preemptively diversify financing risks away from the West. According to Bloomberg, the sale will total 6 billion yuan and could come as early as next week.
Russia hired Bank of China Ltd., Gazprombank and Industrial & Commercial Bank of China Ltd. to arrange investor meetings for the sale of 6 billion yuan ($907 million) in five-year notes, according to people familiar with the plans. The issuance is slated for the end of this year or beginning of 2018, they said, speaking on condition of anonymity because the deal isn’t yet public.
The sale has been under discussion since U.S. and European sanctions in 2014 over the takeover of Crimea blocked many state-owned Russian companies’ access to Western capital markets. A report due next quarter from the U.S. Treasury on the potential consequences of extending penalties to include Russian sovereign debt has increased pressure on the Finance Ministry to seek out alternative means of borrowing.
“It would be wise of Russia to tap the yuan market now,” said Vladimir Miklashevsky, a senior economist at Danske Bank A/S in Helsinki. “China remains Russia’s biggest trade partner, China’s enormous financial system has lots of buying potential, too.”
While Bank of Russia Governor Elvira Nabiullina has said there will be “no serious consequences” from U.S. sanctions on new domestic government debt, economists in a Bloomberg survey estimated the move could add 50 basis points to 150 basis points to borrowing costs.
The Yuan-denominated bonds, known as dim-sum bonds, would be listed on the Moscow Exchange and available for investors to purchase via the Moscow branch of ICBC.
Of course, in addition to advancing Russian diversification interests, a successful sale of yuan-denominated Russian debt would also advance China"s interests in the internationalization of the yuan.
If Russia goes through with the sale, it would be the first sovereign issuance of a yuan-denominated bonds outside of China since 2016, according to Dealogic, with prior issuances in Hungary, Mongolia, the U.K. and the Canadian province of British Columbia.
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.
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) akey 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”.
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.
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 areserve 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
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:
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;
it marks a possible meaningful step preparing for increased (two-way) CNY volatility in the medium term; and
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
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.
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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.
Trading is difficult. If anyone tells you differently, they are either new (and haven’t been hurt yet), or just plain stupid. You are competing in the greatest game out there, against some of the smartest people on the planet.
Even when you do your analysis and get the call right, it is no guarantee you will make money. The Market Gods have a way of making sure that being right is way easier than stuffing dough in your pocket.
The perfect example of this is my call from early in summer regarding China. In May, Moody’s downgraded China, and everyone got their knickers in a knot predicting the collapse of the world’s largest economy. The guru type hedge fund media outlets were filled with grim forecasts of a spiraling 2008 type crisis. These hedge fund managers sure sounded smart, and they all definitely have a lot more money than me, so I was a little timid when I wrote a piece called China Downgrade- Buy the news?.
The gist of my argument was that China would stimulate to make sure their economy was humming along when the hugely important 19th National Congress of the Communist Party was held this Autumn. Proving that a stopped clock is right twice a day, I managed to get this one right.
The trouble was, I didn’t buy the right stuff. I should have loaded up on copper and the other China centric commodities.
Have a look at the copper chart.
China was downgraded, and then copper ran like it stole something.
Same deal with iron ore.
There is no doubt China put the gas pedal down this summer, and it affected capital markets throughout the world.
None more so than the Chinese Yuan. Although most hedgies were all betting on a massive decline, the Yuan has been strengthening like Lance Armstrong after visiting his bio-chemist.
This massive strength has forced at least one prominent China bear to throw in the towel. From Bloomberg:
Mark Hart spent seven years and $240 million waiting on a crash in China’s currency.
He lost sleep. He lost clients. He damn near lost his sanity.
And now he’s lost his conviction: Hart, who called for a more than 50 percent yuan devaluation last year, has turned bullish on China and its currency.
His reversal hasn’t come easily. From his base in Fort Worth, Texas, the hedge fund manager spent countless nights on the line to Hong Kong, parsing market news and exchange rates. At times, the stress took a toll on Hart personally and left his employees demoralized.
“I always thought we had a good risk-reward trade on, but we made a number of mistakes, including being way too early,” Hart, who started the yuan bet after predicting both the U.S. subprime mortgage bust and the European debt crisis, said in a telephone interview. “And now the world has changed.”
In cool hindsight, the 45-year-old founder of Corriente Advisors sees last year’s Group of 20 summit in Shanghai as a key turning point. Like many investors, Hart suspects the meeting resulted in a tacit agreement among world leaders to prevent the yuan from tumbling. He calls it China’s “whatever it takes” moment – when policy makers resolved to prop up the currency at any cost.
“China now has the breathing room it needs to either temporarily stave off a slowdown with fiscal and monetary stimulus, or reform, grow and upgrade itself into the world’s largest developed economy,” Hart said.
Whether or not China got help from other G-20 nations, the government has clearly succeeded in stabilizing the exchange rate. The yuan ended a three-year slide in late December and has rallied almost 7 percent in 2017, including a 0.5 percent increase on Thursday. It’s now trading at the strongest level in more than a year versus the greenback.
Even at its weakest point, the yuan never dropped enough to move the needle on Hart’s wager, which started in 2009. His dedicated China funds, which had fixed lifespans, bought options that were designed to deliver one of two outcomes: a massive payoff in the event of a currency crash, or a near total wipeout if a major devaluation failed to occur.
The trade went against him almost from the beginning. After holding steady for the first six months of 2010, the yuan strengthened for the next three and a half years. It eventually reversed course, but the sharp devaluation that Hart had anticipated never materialized. His second China fund shut in December. All told, he lost between $240 million and $250 million.
When long time bears finally cry Uncle, it’s most likely a short term top. These trades are taken off at a point of maximum pain, not in the midst of a cool, well thought out, investment decision process.
This morning copper is unexpectedly down 1.5%. Gianclaudio Torlizzi, an LME Metals Trader, has posted a couple of terrific longer term charts of Iron Ore and Rebar that show potentially bearish developments.
I know the Chinese have not had their big assembly. But it sure feels like we are close to the point where many of these trades are about to roll back over.
Right now everyone is all bulled up on gold, and extremely bearish on the US dollar. No one can imagine any of the short term trends stopping. I wonder if copper is the canary in the coal mine that a turn is at hand.
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Here is another thought.If China has been goosing their economy for their plenum, then could market strategists be misreading the recent economic global strength? Did China create a false positive for world growth?
I am not sure, but it is worth considering. I have long said that what happens in China is by far the most important determinant of financial asset prices. We all sit staring at US economic releases, but we should really be spending more time trying to figure out what China is up to.
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If a turn in the US dollar is indeed close, then take a look at the Eurostoxx chart.
With EUR screaming higher, it is no wonder that the Eurostoxx has been declining. Yet what happens if USD gets a bid? A break in the Eurostoxx downtrend line could be explosive to the upside.
The world’s top oil importer, China, is preparing to launch a crude oil futures contract denominated in Chinese yuan and convertible into gold, potentially creating the most important Asian oil benchmark and allowing oil exporters to bypass U.S.-dollar denominated benchmarks by trading in yuan, Nikkei Asian Review reports.
The crude oil futures will be the first commodity contract in China open to foreign investment funds, trading houses, and oil firms. The circumvention of U.S. dollar trade could allow oil exporters such as Russia and Iran, for example, to bypass U.S. sanctions by trading in yuan, according to Nikkei Asian Review.
To make the yuan-denominated contract more attractive, China plans the yuan to be fully convertible in gold on the Shanghai and Hong Kong exchanges.
Last month, the Shanghai Futures Exchange and its subsidiary Shanghai International Energy Exchange, INE, successfully completed four tests in production environment for the crude oil futures, and the exchange continues with preparatory works for the listing of crude oil futures, aiming for the launch by the end of this year.
“The rules of the global oil game may begin to change enormously,” Luke Gromen, founder of U.S.-based macroeconomic research company FFTT, told Nikkei Asia Review.
The yuan-denominated futures contract has been in the works for years, and after several delays, it looks like it may be launched this year.
Some potential foreign traders have been worried that the contract would be priced in yuan.
But according to analysts who spoke to Nikkei Asian Review, backing the yuan-priced futures with gold would be appealing to oil exporters, especially to those that would rather avoid U.S. dollars in trade.
“It is a mechanism which is likely to appeal to oil producers that prefer to avoid using dollars, and are not ready to accept that being paid in yuan for oil sales to China is a good idea either,” Alasdair Macleod, head of research at Goldmoney, told Nikkei.
In a comment sure to stir up questions over dollar hegemony (and new world order conspiracy thoughts), IMF Managing Director Christine Lagarde admitted during an event today in Washington that The International Monetary Fund could be based in Beijing in a decade.
As Reuters reports, Lagarde said that such a move was "a possibility" because the Fund will need to increase the representation of major emerging markets as their economies grow larger and more influential.
"Which might very well mean, that if we have this conversation in 10 years" time...we might not be sitting in Washington, D.C. We"ll do it in our Beijing head office," Lagarde said.
“China has started reporting our foreign official reserves, balance of payment reports, and the international investment position reports.”
“All of these reports, now, in China are published in U.S dollars, SDR and Renminbi rates… I think that has the advantage of reducing the negative impact of negative liquidity on your assets.”
What that means in real terms is that China views the opportunity of being a part of the exclusive world money club as an opportunity to diversify away from the U.S dollar.
The Bank of China official took that message even further saying that he hopes that China could lead in world money operations by integrating it into the private sector.
“If more and more people, companies and the market use SDR as unit of accounts – that would generate more activity in the market with focus on the MSDR. [The hope would be] that they could create more products and market infrastructures that would be available for trade products to be denominated in SDR.”
The People’s Bank of China official referenced how this trend was already underway. Just last year Standard Chartered bank began to maintain accounts in SDR’s. “In terms of the first and secondary markets they will develop fairly well.”
Perhaps the most important segment that the Chinese official signaled was his reference that, “The Official Reserve SDR (OSDR) that allocation from the IMF is very important. [This allows] Central Banks to make the SDR an official asset, and easier for them to convert that asset into the reserve currency they need.”
What that means is that China will become an even greater player in the world money market.
Nomi Prins, an economist and historian stated when analyzing China’s economic positioning, “The expanding SDR basket is as much a political power play as it is about increasing the number of reserve currencies for central banks for financial purposes.”
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As a reminder, the IMF"s bylaws call for the institution"s head office to be located in the largest member economy and since the IMF was launched in 1945, that has always been the United States, which currently has an effective veto over IMF decisions with a 16.5 percent share of its board votes.
But, as Reuters notes, economists estimate that China, with growth rates forecast above 6 percent, will likely overtake U.S. gross domestic product sometime over the next decade to become the world"s largest economy in nominal terms.
Some, including the IMF, have argued that China already contributes more to global growth on a purchasing power parity basis, which adjusts for differences in prices.
The IMF last revised its quota system, or voting structure in 2010, but is set to launch another review next year.
In the movie "The International" Clive Owen plays the part of Louis Salinger, an Interpol agent trying to bring down the world"s largest bank.
In this clip a banker explains things to him:
Umberto Calvini: [In explaining the "true" nature of banking in the world]
"The IBBC is a bank. Their objective isn"t to control the conflict, it"s to control the debt that the conflict produces. You see, the real value of a conflict, the true value, is in the debt that it creates. You control the debt, you control everything. You find this upsetting, yes? But this is the very essence of the banking industry, to make us all, whether we be nations or individuals, slaves to debt."
Debt is much like a baseball bat: neither good nor bad. You can use it to hit the ball out of the park or you can get beaten into a bloody pulp by it. How we use (or abuse it) is the determiner. Read my article on the easy and uncomplicated way to get rich to ensure you go about it the smart way.
Certainly debt can - and has been used - to control people, assets, and entire societies ever since we crawled out of the cave and began covering our bits with fur. Just ask your neighbour Billy, who"s always complaining about his sh*tty job, why he won"t shut up and just quit? The answer typically is because his mortgage and car payments won"t let him.
I"ve been thinking a lot about debt lately. Not the consumer driven silliness highlighted by Billy but specifically how debt is used as a tool on an international and political level and how it affects currencies and geopolitics.
I then looked at the unfolding trends present today. Trying to see how they all fit together is, I believe, a valuable exercise, even though there"s more moving parts to this than a silo full of Swiss watches.
To begin with, let"s revisit some recent history of debt, currency, and deficits and how they"ve interacted. George Soros articulates it very well in his book The Alchemy of Finance when describing what he called "Reagan"s Imperial Circle:"
Keep this concept in mind as we"ll revisit it in a minute.
Trends
Fast forward to today, and there are some dramatic shifts taking place in the world:
Bureaucrats in Brussels, who specialise in overpriced corporate lunches and finding new ways of spending their unjustifiable annual bonuses, continue to berate the "PIGS" for not doing more about austerity. Ironic but the truth is Brussels controls the PIGS much in the same way the bankers in the movie The International controlled the world
Across the Atlantic we have the sexiest first lady in forever elected, and now we enjoy her orange husband bring a whole new level of ridiculous to Twitter, a space previously owned by the Kardashian"s posteriors. I"m still undecided which is worse
On the shores of the murky isles, Brits marched boldly towards independence only to realise in shock that they had a completely inept leadership and not a single able minded option available to them. And so they did what any pissed off aggravated person would do: they began voting for Jeremy Corbyn. Not because anyone wanted him in power. Hell no! Purely in protest
And so, while much of the West increasingly looks dysfunctional, lost, and confused, China are embarking on the most ambitious project ever since I tried to convince my now wife that a hot girl should marry me. The project? One belt one road (OBOR), which impacts many industries and countries such as Greece.
In many ways China has many elements in their favour whereby they can use their increasing economic prowess, large trade surplus, and existing overcapacity to control the debt of trading partners, and in so doing slowly but surely influence politics and economics in a self reinforcing cycle.
Incidentally, if they"re successful in their OBOR endeavours, they can hope to mitigate some of the fallout from an impending and overdue domestic non-performing loan cycle.
Commentators on OBOR seem to fall into those who are bullish... and those who poke fun at it and either don"t like it or question China"s ability to pull it all off. On the face of it the idea seems simple enough. OBOR promises to open up markets for Chinese exports. This is, I think, somewhat simplistic and naive.
The more I"ve researched the topic the more I think there is much much more to OBOR than meets the eye. The Chinese are many things but stupid is not one of them.
Let"s take a look at some of their problems, their ambitions, and how and why OBOR really is front and centre for Xi.
Overcapacity
We know that too much of anything is bad for us. Just ask Chris Christie"s arteries.
China suffer from too much capacity as well as too much domestic debt in their banking system. OBOR may provide a means for China to deflate this debt while exporting overcapacity.
What"s more is that they can do so while providing credit (at the state level) to countries who are in desperate need of it. Greece, as I mentioned last week, fits this picture particularly well.
Deflating the Domestic Credit Bubble
China has a domestic credit problem, and they"re going to have to deal with that in some way or another. Certainly a harsh non-performing loan cycle can punish GDP growth but consider this...
What if China essentially moved this domestic debt problem onto the balance sheets of OBOR partners?
How?
By the Chinese government lending these partners money for large infrastructure projects (as they"ve already been doing). When those infrastructure projects get built, a decent amount of the project works go to Chinese companies which provides them the ability to both export overcapacity all the while deflating some of the domestic credit bubble.
A pretty damn smart move if you can pull it off!
China has some $3 trillion of paper which they can trade for power and influence.
Think about it, which would you rather have: a pile of greenbacks (with the Fed at the helm who have shown in no uncertain terms that, when push comes to shove, they"ll forego monetary stature for domestic political security) or political and economic leverage globally?
The Most Powerful Weapon Brought to Bear
China"s answer is pretty clear based on what they"ve begun to do.
They have already been making huge loans to strategically placed and often poor countries. These loans provide jobs and infrastructure, both of which are desperately needed by these countries.
That they"re structured on onerous terms and under conditions whereby Chinese materials and labour are often used is easily overlooked when one is broke and desperate (in the private investment world we call it distressed investing). And in case you"ve not realised it, there are a lot of desperate governments littering the planet right now.
And just like in the movie referenced, China need not have these projects even be successful. In fact, there"s a case to be made to say that they"d prefer them NOT to be successful. Having the debt repaid eliminates political and economic leverage.
Case in point: Sri Lanka’s Mattala Rajapaksa International Airport, which opened in 2013, is still largely idle and empty. What does Sri Lanka now get? An empty airport and a massive debt to China which they can"t repay. Pakistan"s multibillion dollar Gwadar port and Greece"s Piraeus port are two more.
China controls all of this debt, and by controlling this debt they can, and will, begin using this power for... ahem, "concessions".
The world should not be surprised when military submarines with Chinese symbols start using these ports and Beijing begins having a say in how these partner countries" "assets" are used and by whom, because, after all, China controls the debt.
Neither should we be surprised when Chinese warships begin providing "security" to these ports, or when "security and surveillance" aircraft belonging to the Chinese military begin providing "services" to the airports, gas pipelines, and so forth.
Realise that it"s in China"s interests for these countries to never ever be able to repay these debts. This provides them with extraordinary leverage at what is really a very cheap cost.
Now, I"m not that cynical that I think China doesn"t want this infrastructure to help trade. I"m sure they do. But there is likely a strong political incentive here which really amounts to a bait and switch loan sharking game where countries will be forced to make all sorts of concessions in order to defray debt payments.
My readers are a sharp bunch so don"t need me to point out that this is a far cheaper method than the "normal" alternatives.
Consider that the cruise missiles Trump rained down on Syria just 3 months ago cost an estimated $60 million, and the Iraq war has already cost the US government, I mean US taxpayer, $2.4 trillion.
I began doing the math on the total amount of money spent by the US government on gaining or maintaining geopolitical dominance via military interventions but my calculator started smoking and promptly blew up. But it"s definitely safe to say it"s a lot higher than these two numbers.
As I mentioned before, the economics of war have changed, and OBOR represents a vastly cheaper method of acquiring power and influence than does bombing the sh*t out of sand.
Russia’s second largest trading partner (after Germany)
Africa"s largest trading partner
South America’s largest trading partner
OBOR is much, much more than simply establishing trading routes for Chinese goods as the MSM will have you believe. It is THE most ambitious geopolitical play of our lifetimes, and it"s well worth understanding what"s taking place here.
Xi"s Imperial Circle?
So the question that I have for you to ponder today is this: is China able to create a self-reinforcing mechanism whereby they export excess capacity, deflate a domestic credit buildup, build an infrastructure for future export and trade all the while having many of the participants beholden (via debt) to China allowing for unsurpassed geopolitical power... and be able to do so because, in large part, the rest of the world has their own problems to wrestle with?
Does the world wake up a couple decades later when the dollar debt has been converted (another concession) to renminbi and marvel at what an amazing chess manoeuvre was played as we all realise we have Xi"s imperial circle?
"Happiness does not fall out of the blue and dreams will not come true by themselves. We need to be down-to-earth and work hard. We should uphold the idea that working hard is the most honourable, noblest, greatest and most beautiful virtue." — Xi Jinping
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.
He warned about the ballooning asset-liability mismatch in the shady $4-trillion wealth management products (WMPs) market.
And went on to say "this is the beginning of the Chinese credit crisis" while admitting it could take some time for things to really start unraveling.
A fair call...
How many of us have figured the trend out, only to allocate too much capital to a trade and even lose on a trade which finally works... eventually? I know I have. I"m pretty sure Kyle"s position sized pretty well. After all, this is far from his first rodeo.
In the interview Kyle referenced an SCMP article from a few weeks ago that went largely unnoticed by most. It was on the Chinese government coming up with more and more creative ways to stem the capital outflow underway since mid-2014:
"China"s foreign exchange regulator, SAFE, has asked for cooperation from multinationals, including Sony, BMW, Daimler, Shell, Pfizer, IBM and Visa, to manage and control the flow of capital out the country."
This all feels a bit deja vu-ish.
Long-time readers will know we"ve been bearish on China and the renminbi for well over 2 years now. Back in October 2014 we said that:
"I don’t know exactly how a breakdown in the renminbi will play out. However, it is a sure bet that all those markets that prospered over the last 15 years or so on the back of a China will do badly. Where things become shady is the collateral damage to other markets that have had nothing to do with the Chinese economic miracle."
"The interbank lending market is an integral part of any country’s banking system as it is where banks maintain their short-term liquidity requirements. Often a bank will have a mismatch between between short-term assets and obligations and as such they will have to enter the interbank lending market to maintain optimal liquidity. If a bank has excess short-term reserves they may want to lend these out to other banks who have a shortfall in short-term reserves. The opposite also occurs where a bank, with a short-term funding deficit, will enter the market to borrow funds to match short-term liabilities.
The behavior of the interbank lending market can provide one with a good appreciation for the liquidity of the banking system as a whole. If there is a lot of liquidity in the system (more short term assets than liabilities) the interbank rate will fall, if there is scarcity of short term assets relative to liabilities then rates will rise. So a rising interbank rate is generally associated with contracting liquidity conditions. Rapid rises in interbank lending rates are often associated with banking or credit crisis. This happened in the lead up to the GFC. What happened was that as banks began to fear the ability of other banks, who are their counter-parties, to make good on their obligations they demanded higher rates especially from banks already facing liquidity problems which only compounded their original the situation.
A rapid rise in a country’s interbank lending market is also a good predictor of the direction of a country’s currency, or at worst a confirming indicator. Let’s have a look at the interbank lending market of a few emerging nations over the last 12-18 months and then look at what is happening with the renminbi. I think it is instructive for what we have been positioning for in our funds."
In truth, it was an easy bet to make.
Volatility was around 2%! NOT buying put options would have been like having Scarlett Johansson invite you into her bed and then falling promptly asleep. You just couldn"t do that. And so you had to buy.
Taking a look at the Chinese interbank lending today:
Not yet getting critical but worth watching.
And pricing of the options:
So a 6.6% move to make 100%. Seems reasonable but nowhere near as good as it looked in late 2014 - unfortunately.
The problem - if there is one - is that 12 months is a long time to date an ugly girl, work for a nasty boss, or drive a Lada. But it isn"t a particularly long timeframe to hold an option for.
And yet that"s the best the option market gives us.
Sure, you can throw your towel into the ring in the futures markets but if, like me, you dislike leverage and margin calls (because you WILL get it wrong at some point), then you"re going to have to figure some better way to ride this pony.
I serve on the Board of Directors of a large Singapore-based company that’s in the gold and silver business.
And, last night during our quarterly conference call, the management team gave me a lot of intriguing information.
Sales of physical gold and silver are collapsing across the entire industry.
At the US Mint, for example, sales of US Eagle gold coins fell by 67% between February 2016 versus February 2017.
And sales of US Eagle silver coins are down 75% over the same period.
The World Gold Council’s data also shows a substantial decline in physical precious metal demand in 2016, particularly with bars, coins, and jewelry.
Suppliers and refiners in the precious metals business are echoing these numbers, lamenting that sales are extremely slow and margins are falling.
For our Singapore company, this decline is irrelevant.
They have their own proprietary, state-of-the-art storage facility and a number of cutting-edge service like bullion-backed peer-to-peer loans, so business is great.
But I would expect that a number of other bullion dealers will probably go bust if this downturn lasts much longer.
The one conundrum is that this trend does NOT correlate with the price of gold.
In US dollar terms, the gold price is up 16% since the beginning of 2016.
So it would be reasonable to conclude that sales of physical bars and coins are up as well.
But they’re not.
The reason is because there’s a HUGE difference between physical gold and “paper” gold.
When people talk about the gold price, they’re really quoting the price of gold contracts at exchanges around the world in London, Shanghai, Chicago, etc.
Traders aren’t actually buying and selling physical gold.
These gold contracts are merely paper financial instruments, like stocks and bonds, that traders use for speculation.
When some conflict breaks out in Africa, the knee-jerk reaction is for traders to buy gold contracts.
And when central bankers announce that the economy is totally awesome, traders dutifully dump their gold contracts.
But they’re really just buying and selling highly leveraged paper assets. Nothing physical changes hands.
It’s the same with gold ETFs; these are merely financial instruments to gamble on the paper price of gold.
Investors who truly understand the benefits of owning gold, and don’t simply want to speculate on the price, buy physical bars and coins from a dealer.
And quite often there’s a massive difference in fundamentals between the demand for physical coins and the paper price.
During the 2008 financial meltdown, the paper price of gold and silver plunged.
Speculators and traders were hit by margin calls and forced to sell their contracts.
But demand for physical coins was incredibly strong; savvy investors were looking for a safe haven.
There was a total disconnect between the paper price and physical demand.
That’s now happening again, but in reverse. The paper price is rising, but physical demand is falling.
Management told me last night that they’ve been invited to speak at several investment conferences attended by family offices and high net worth individuals.
But they told me that there’s very little interest in owning physical precious metals among these wealthy investors.
Everyone seems to want to dump all of their money in US stocks or real estate, expecting that they’ll easily make 20% despite both markets being at all-time highs.
This strikes me as total madness. Few people ever prospered buying what was popular and expensive.
There seems to be no fear in the market… no regard for sense or safety.
And my contrarian instincts tell me that this complacency is a great reason to own physical gold and silver right now.
Remember that gold is primarily a form of savings.
You could hold your savings in a bank account, denominated in paper currency like dollars or euros or renminbi.
Or you could hold savings in physical cash. You could even own government bonds.
Each of these is a form of savings.
But so is gold and silver. (And cryptocurrency, for that matter.)
The difference is that gold and silver cannot be conjured out of thin air by a central bank.
And unlike cash, or money in a bank, precious metals actually keep pace with inflation over time.
I remember having a conversation once with a famous investor who told me that he didn’t know what was going to happen in the future…
… and THAT’S why he owned gold– for the “I don’t knows.”
Will there be a trade war with China in the next few years? A shooting war? A major debt crisis? Another terrorist attack? “I don’t know.”
Gold and silver are fantastic insurance policies against the “I don’t knows” due to the metals’ 5,000 year history of value and marketability.
There’s no need to go overboard and keep 100% of your net worth in precious metals.
But given the obvious risks on the horizon that we discuss regularly, and these bizarre demand trends, it’s a great time to consider adding to your physical precious metals savings.
In what could be the beginning of ripples from The Fed"s jawboned "certainty" of a March rate-hike, Chinese money market liquidity conditions appear to be drying up once again as overnight offshore yuan rates surge 142bps to one-month highs.
Additionally, 1-week CNH Hibor +1.05 ppts to 4.53017%; and 1-month CNH Hibor +70bps to 4.9395%
At the same, spot offshore Yuan rates have plunged to their lowest since January 4th"s massive short squeeze.
As it appears 2017 is Shangahi Accord Redux time - (China "agrees" to weaken the Yuan against non-USD currencies, while "stabilizing" the Yuan against the USD... until that breaks)
The question is - will a sudden renewed but of volatility in credit markets (high yield crashed this week), commodity markets (crude and copper collapse this week), emerging market stocks (tumbling), and now China money markets, be enough to stall a determined Fed, and crush their credibility once and for all?
The volatility in the Chinese currency has gone from the sublime to the ridiculous. After exploding 21 handles stronger in the biggest PBOC-engineered short-squeeze in history - erasing the entire post-election sell-off - offshore Yuan is now collapsing once again, down 350 pips tonight (and over 10 big figures from Thursday"s highs). While interbank rates have calmed down, the rush to exit the currency has not...
The last two days are the biggest drop in offshore Yuan since Aug 2015"s devaluation... as PBOC weakens its fix by the most sine June 2016.
Pushing historical volatility to its highest since the Aug 2015 devaluation...
For some context, this level of volatility is over 10 standard deviations away from the pre-Aug 2015 norms.
Notably the moves accelerate afterPBOC Advisor Fan Gang told Bloomberg TV...
*PBOC WANTS TO SEE FX RESERVES REDUCE SMOOTHLY, GRADUALLY: FAN
*CHINA POLICY MAKERS NOT LIKELY GO FURTHER ON OUTFLOW CURBS: FAN
*YUAN OVERVALUED IN PAST 3-4 YEARS AGAINST DOLLAR: FAN
*CHINA POLICY MAKERS NOT LIKELY TO DROP INTERVENTION: FAN
*USE OF YUAN HAS INCREASED DESPITE RECENT DEPRECIATION: FAN
*CHINA NEEDS LESS FX RESERVE AFTER YUAN"S INCLUSION IN SDR: FAN
Which was followed by the state-run Global Times newspaper says in an English-language editorial, saying that the Chinese people will demand its government to “take revenge” if Donald Trump reneges on the one-China policy after becoming U.S. President.
The heavy exodus of the Chinese renminbi from mainland China put pressure on the country’s economy. In an effort to stymie the outflow, the Peoples Bank of China (PBOC) enacted new rules that are meant to help it exert more control over its currency…and that could spell trouble for the Canadian real estate market!
A CANADIAN REAL ESTATE “BUBBLE”
It is well known that the global financial crisis of 2009 was precipitated by a housing “bubble”in the United States. Real estate analysts south of the border, and even some local market watchers here in Canada, have long been predicting a similar bubble of sorts brewing in Canada. However, the Canadian “bubble” seems to have a much different origins.
The Canadian Perspective
It has long been suspected that the booming housing “bubble”, in great Canadian metropolitan cities like Toronto and Vancouver, was partly inflated as a result of foreign buyers. Predominant amongst those foreigners were property buyers and investors from China. Desperate to diversify their investments, and find better use of their capital outside the mainland, Chinese buyers are rumoured to be piling into real estate in large cities like Vancouver and Toronto.
According to industry analysts, home prices in British Columbia increased from 6.6% year-over-year in 2014, to 20.5% in 2016; while Ontario saw increases from 5.2% to 11.6% over that same period. Clearly, by some definitions, this is a bubble in the making.
The Chinese Perspective
Every sovereign nation wants to (in fact must!) have maximum control on its currency, and China is no exception. However, once currency is converted into foreign exchange and sent out of jurisdictions influenced by the country, “control” becomes even more difficult to exert.
The large outflow of currency from China is a concern to the authorities there – and they decided late last year to do something about it. Among some of the exchange control measures include:
Making it harder for individuals and institutions to convert renminbi into other currencies
Enforcing greater restrictions on transferring money from the mainland to other international jurisdictions
Requiring more transparency on the intent and motivation behind foreign exchange transactions
Mandating greater punishment for individuals and institutions who run afoul of the new rules
While large Chinese corporations and global real estate players may still be able to skirt around these new regulations, it is expected that a large amount of property investment transactions by individuals could be impacted. As a result, Canada, and especially hot beds like Vancouver and Toronto real estate, should brace for potential fallout.
MORE THAN A CHINA CONNECTION
While China’s new forex rules will definitely put a damper on many Canadian real estate companies business plans, there is more bad news for the industry – largely emanating from within Canada. Both at the federal and provincial levels, governments are concerned about facing similar repercussions as that seen by our southern neighbor because of housing bubbles faced there. As a result:
In February 2016, the government of British Columbia implemented a new tax rate of 15% for properties sold in excess of $2-million; while also mandating collection of more data on foreign buyers
At the same time, the BC government also empowered municipalities like Vancouver to tax “empty homes”– mostly foreigner-owned investment properties that are vacant; waiting to be sold at a huge profit
On October 3, 2016, the federal government imposed more stringent rules for mortgage insurance, raising the barrier for high-ratio borrowers to qualify for loans
Additionally, through that same legislative move, some loopholes in Canada’s tax code, which were being used for preferential tax treatment by foreign buyers and non-permanent residents, were closed
All of these moves are billed as initiatives that will ultimately make housing more affordable in hot markets like Vancouver and Toronto. However, their impact will be far-reaching in terms of broader impact to the nation’s real estate market.
Early Signs
It is too early yet to tell whether the new regimen will have any impact on Canada’s housing industry. But based on early reports from B.C, it does look like they are having a cooling effect, at least in the Vancouver area.
Since the new Canadian/B.C rules took effect, there has already been a marked decline in foreign investment recorded in Vancouver. According to the B.C government’s information, foreign purchases in Metro Vancouver, which also includes Chinese purchasers, accounted for roughly 3% of the region’s residential real estate transactions from June 10th to October 31st, 2016. This number has dropped well below the 13.2% rate for similar transactions prior to the new legislation.
WHAT THE FUTURE HOLDS
The end game for China’s new currency export policy is to detract its citizens from annually spending an estimated $15 to $20 billion overseas. But China-analysts seem to think that, even though the country’s new forex laws are tightening the noose around real estate investors who may be contemplating Canadian investments; such transactions will likely not decline substantially – at least not in the immediate future. New ways to get renminbi out of China will evolve within months of old ones being shut down!
Canadian real estate industry analysts however seem to have a different take on the issue. According to Canadian property market watchers, the number of resale homes projected for resale in 2017 across Canada are expected to fall by around 11.5% (compared to 2016); with B.C leading the pack (-23.8%), and Ontario (-10.5) declining by double-digits.
This one-two punch, by federal and provincial jurisdictions, to the real estate market doesn’t bode well for the real estate industry, but especially for property owners. Researchers believe that the collective impact of the new housing regimens – both from China and from within Canada – will contribute to much slower increases to property values.
Researchers forecast that on a national level, the average Canadian home’s resale value will increase by only 1.6% in the New Year, compared to a robust 9.5% increase in 2016. Ontario homes are set to post their weakest rate of increase in over 8 years – at 3%; while B.C home prices will rise by 1.9% (compared to a staggering 20.5% in 2016).
With not much information available as of yet, about the impact of the policies discussed here, it is hard to predict what impact they are having on the country’s real estate industry. One thing is definite though: None of the steps implemented so far, by both China and various jurisdictions within Canada, seem “investor friendly”.
