China Approaches Breaking Point

We’ve discussed it for weeks. But today we have it on the highest authority, Bloomberg, that “China’s Currency Policy Approaches Breaking Point.”

What is the breaking point? Why does it matter? And how does Trump factor in? These are the questions we tackle today…

China announced yesterday that its foreign currency reserves have officially fallen below the $3 trillion mark — a psychological line in the sand.

After yesterday’s announcement, they stand at $2.99 trillion — and falling. Many analysts estimate China needs a $2.6–2.8 trillion cushion to forestall a balance of payments crisis.

But now that the line in the sand has been crossed, many fear the decline will accelerate. So China must stop the hemorrhaging. And soon.

Rajiv Biswas, economist at Singapore’s IHS Global Insight: “With reserves dropping below the psychologically important threshold of $3 trillion, this will further ramp up pressure on Chinese policymakers to prevent the further draining of reserves.”

The problem in a nutshell:

A worsening debt crisis and slowing growth have capital fleeing China as fast as its feet will allow. The Institute of International Finance reports that capital outflows swelled to a record $725 billion last year.

China’s desperate to keep that capital at home to support the economy. And it’s been burning holes in its dollar reserves to support the yuan. Selling its dollar holdings to buy yuan puts footings under the yuan. Makes it more attractive. Halts the capital flight.

But the fire can only burn so long before it torches the remaining reserves…

A $2.99 trillion war chest or a $3 trillion war chest sounds like plenty. But as Jim Rickards explained recently, it’s not nearly as much as it sounds:

Of the $3 trillion that China has left, only $1 trillion of that is a liquid. One trillion is invested in hedge funds, private equity funds, gold mines, et cetera. That money is not liquid. It cannot be used to support the currency, so remove a trillion.

That leaves $2 trillion:

Another trillion has to be held on what’s called a precautionary reserve to bail out their banking system. The Chinese banks are completely insolvent. That system is going to need to be bailed out sooner rather than later.

Scratch another trillion:

That leaves only $1 trillion of the original $4 trillion in liquid form. The problem is that capital flight is continuing at a rate of $1 trillion per year, so China will be devoid of usable liquid assets by late 2017.

Repeating: Two-thirds of China’s reserves are doing other service. About $1 trillion remains. But at the going rate, China will burn through its usable reserves by the end of the year.

So now what?

Jim has warned that Trump could soon label China a currency manipulator. That has vast implications, as you’ll see. But it’s not just Mr. Rickards. We learn today that a group of analysts at Deutsche Bank is piping an identical tune:

Sometime in the next few weeks, President Trump or his Treasury secretary may declare China a currency manipulator and propose penalties including tariffs on some or all imports from China unless it ceases this and other alleged unfair trade policies.

And that would invite Chinese retaliation. Tariffs of their own on American goods. And then… China might reach for the nuclear option — a “maxi-devaluation.” Jim again:

We know what Donald Trump has said. China’s going to be labeled a currency manipulator. That’s like firing the first shot in a major currency war. We could see tariffs imposed in both directions, shots in retaliation, a financial war… China will retaliate with what I call their nuclear option, which is a maxi-devaluation of the Chinese yuan.

If China’s going to be branded a currency manipulator and have its exports slapped with a steep tariff, why not go ahead and devalue?

One, it would make Chinese exports more competitive. Two, China could stop depleting its dollar reserves. It would no longer have to burn through dollars to boost the yuan.

And three, it could actually halt the capital outflows. How? Many Chinese fear the government will impose stricter capital controls as the situation worsens. So they move their capital out of the country in advance. That brings greater fear of capital controls. And more incentives for capital flight. It’s a vicious cycle.

But if China devalues all at once, say, 25% or 30%, it sends this message: The worst is over. You may as well keep your capital in China. There will be no further devaluation.

As far as China’s concerned, so what if the U.S. stock market tanks 10% or more? It bounced back the past two times they devalued, August and December 2015. It’ll bounce back again. Besides, China’s a lot more concerned about keeping its factories humming than the U.S. stock market.

Regardless, China can’t afford to keep burning through its dollar reserves.

“It’s clear that China’s current currency policy is unsustainable,” writes Junheng Li, founder of Warren Capital. “It can, of course, last longer than anyone anticipates and then abruptly end.”

If Jim Rickards is right and those Deutsche Bank analysts are right, it could abruptly end sooner than most people think. The next few weeks could be critical. Will Trump label China a currency manipulator? And will China then “go nuclear”?

All eyes are on you, Mr. President…

Regards,

Brian Maher
Managing editor, The Daily Reckoning