Sitting here in Hong Kong, I know few people who aren’t transferring money into China to take advantage of the appreciating RMB and attractive domestic rates. In fact a study conducted by the Chinese Academy of Social Sciences estimates there could be over USD1.0trn of such money within China, with USD150bn coming during the first five months of 2008. The good news for these investors is that the RMB is still expected to appreciate over the next 1 to 2 years as the Chinese government continues to correct economic imbalances. However, there is bad news. Eventually, the RMB appreciation will peak, and those investors’ solely within the country to take advantage of the appreciating currency will begin to pull-back. This will likely cause liquidity problems within the Chinese economy, and will lead to further depreciation as more investors attempt to withdraw their funds. This potential crisis has not gone unnoticed. *The branch head of the Jiangsu province China Banking Regulatory Commission released in a paper this week the following comments;
“The initial judgment is that China's financial crisis will kick off between 2009 and 2010, though it may be a year or two later, and will be triggered by a turning point in yuan appreciation…”
“By that time, international capital will flow out instead of coming in and the yuan will face depreciation instead of appreciation pressure. China will face a liquidity shortage and financial crisis will therefore follow.”
In fact looking at the RMB NDF rates, we can see that the market is currently pricing in a slight RMB depreciation around the 3-year time horizon (chart below). In fact, back in May we even saw the 1-month contract briefly imply depreciation for the RMB, demonstrating the potential volatility of the market. This notwithstanding, we have begun to see the growth rate of Chinese exports slow, a trend we expect to continue. This coupled with an unwavering demand for imports, will place a stronger weight on the domestic sector to support China’s growth. To make matters worse for the export sector the Chinese government has initiated new capital controls to reduce the amount of 'hot money' that may be hidden within the sector (i.e. through over-invoicing). Some estimates have placed the amount of hot money hidden within the sector at around 2% of exports. The good news is that the increased importance of the domestic market within China could cause the government to reduce some restrictions on the sector, meant to reduce over-heating within the economy. Yet, a conundrum could arise if Chinese inflation rates once again begin to accelerate. However, at this point most analysts’ estimates are calling for inflation to slow.
The Current RMB NDF Implied Rates show the RMB Depreciating Slightly in 3-Years
The bottom line is that China is facing a potential financial crisis that could occur sometime over the next 2 to 4 years. I will continue to look at the RMB NDF market and changes to the government’s foreign exchange policy as potential forward looking indicators to this crisis. In the meantime, the slow-down in Chinese exports will likely have 2 short term effects, 1) a decelerated RMB appreciation, & 2) the potential for authorities to lift some regulations put in place to prevent the domestic economy from over-heating. This could have positive effects on the local equity markets, after facing significant losses from their previous highs. In fact, last week we already began to see the local equity markets respond favorably to the possibilities of less stringent economic policies.