Q&A: Is China About to Impose Capital Controls?

Let’s look at a couple of questions from the readers today, shall we?

Hi Chris,

I love your sharing of thoughts. Really insightful and though you may not realise it, you’ve helped me a lot. I’m an entrepreneur running flat out. I’m juggling so many things, some inevitably fall through the cracks and yet I feel like I have to beat my competitors. You and your team there have such a long and deep experience in investing, including early stage investing. As such, I figure you’ve seen a lot of guys in my position. What suggestions do you have? I’m losing my mind.

Without knowing your business, your comment reminded me of an event which sticks in my mind to this day.

Many years ago, as a teenager, I was on my way to a part time job. I had only recently begun driving, and as such my car was a heap of scrap, about as aerodynamic as a quarry face. One day, driving in traffic, I witnessed another guy who cut me off as he was in a desperate hurry, trying to dodge in and out of two lane traffic going in the same direction. He was driving a lovely shiny new BMW and was red faced, and clearly about as agitated as a mosquito bite in the heat. I was in no particular rush and just going with the flow listening to music.

The journey to my place of work was about 20 kilometers. When I arrived into the car park, lo and behold, there was this guy climbing out of his car. He’d managed to dodge, weave, drive his car as hard as he could, when he could, and emotionally was close to snapping. He had arrived at the same destination maybe 40 seconds before me but in a completely different state.

What he should have done really is use his time as effectively as he could. He was trying to do something which was out of his control, namely get to where he was going faster than was really possible given the circumstances.

I’m as guilty as anyone on this but it’s really important to focus on what’s important not what’s urgent. Understand that they’re not the same thing.

Now, this next comment is not something I would normally bother publishing but I thought I’d share it since it does show some of the current zeitgeist where unsophisticated investors will make decisions not on any intellectual thought process but on something as inane as how many Twitter followers someone has. Social media reigns supreme.

I was put onto your site by my financial advisor. The material is interesting but I notice that you’ve not got a lot of Twitter followers.

Mmm… OK, then. Maybe I should focus less on investing my capital and more on my Twitter followers. I could care less if I only had 12 followers. Seemed to work for Jesus…

If I stopped posting any content would the value of my thoughts and investment insights be less? As a matter of interest, I receive daily solicitations from “internet marketing professionals” who will deliver me any number of Facebook fans, Twitter followers, LinkedIn friends and more. Just sayin’.

Onto the next one…

Hi Chris

Thanks for the fantastic analysis of the RMB. I signed up literally just in time. I think the second article I read was on shorting the RMB and it made sense so I put it on even though at the time I stubbornly felt that the USD was going to hell. Something I’ve changed my opinion on after reading through your many posts and reports on the topic.

I read a lot of commentary suggesting the the RMB would become the new world currency and that it would revalue higher. Your work was less emotional and just looked at the facts which swayed me.

My question, if you’d be so kind to answer. You guys detailed how the USD carry trade created a demand for RMB but surely when those dollars enter China, or any recipient country they would ultimately land up as foreign exchange reserves. Furthermore, China then would have massive USD foreign exchange reserves meaning that the RMB should be more not less stable in a dollar rally. How do you think about this?

Thank you! I suggest you try to forget about the noise and look at the numbers first. Once you’ve looked at the data then listening to divergent opinions is much easier. You’ll rapidly identify a professional from random opinionated people cluttering the net selling fear, mayhem and catastrophe at every corner, or whatever is the flavour of the day (see my comments about Twitter above).

To answer your question. When the dollars came into China, largely due to them being made incredibly cheap due to Fed induced QE, this put upward pressure on the RMB – something the PBOC didn’t want.

As an example, if you invested capital into something like a RMB CD then those dollars end up on the balance sheet of the Chinese bank. Chinese banks however aren’t typically in the business of lending out dollars but rather RMB. As such they sell the USD in the interbank market to obtain RMB which they can lend out. Banks are in the business of lending.

That particular trade would cause downward pressure on the dollar (sale of dollars) and that’s not a good situation for an export driven economy such as China. As such the PBOC comes in and buys those dollars but to do so they print RMB thus creating a balance sheet debit. They effectively sterilize the purchase of RMB made by the Chinese bank.

Everyone was happy with this scenario as dollar financing of China’s boom continued, GDP growth targets kept being met, and the RMB peg to the dollar was largely kept in check. What’s more the RMB – even though sterilization was occurring – was allowed to rise, thus creating a risk cushion on the currency swap by those short dollars. This itself incentivized more of the same behaviour.

The problem is that for every action there is a consequence to that action. The net result is the PBOC balance sheet expanded as they either issued RMB denominated bonds or bills in exchange for the purchase of those dollars. They now have yuan denominated liabilities in massive quantities.

This all worked so long as growth continued and so long as those RMB which the original bank had now lent out went into productive assets and there was no loan quality deterioration. Of course, that’s not what’s been happening. Since such large quantities of dollars were pouring into China, based on the growth story, so too the PBOC was creating insane amounts of RMB to sterilize those incoming dollars.

That incredible creation of RMB had to go somewhere and it’s gone into, among other things, building of famous Chinese ghost cities. The incentive for this behaviour was compounded by the fact that Chinese government officials are rewarded based on GDP growth. Building useless ghost cities shows up as GDP growth but it’s completely unproductive despite what Paul Krugman may have to say about it.

This is now a problem on multiple fronts:

  1. QE in the US has stopped and those same stimulative policies have NOT stopped in countries such as China. This divergence helps to create an additional bid for the dollar. The Fed doesn’t need to raise rates right now as there exists a synthetic tightening. When the rest of the world is easing and the US stops easing then this is dollar positive.
  2. The China growth story is now seriously in question. Without continued growth the trade unwinds.

Combine this with the size of the carry trade we’ve discussed at length, and we have an incredible setup to make a lot of money as this plays out. What will continue to take place is foreign exchange outflows from China. At what point do we not just call it what it is? Capital flight.

History tells us that capital flight is often followed by tighter capital controls, and ironically it is capital controls which will only exacerbate the pressures, meaning that when the final twig snaps the collapse comes all the harder. The pressures for China to devalue will only continue to mount and implementing tighter capital controls will not aid China in its bid to have their currency included in the SDR basket by the IMF.

– Chris

“The function of leadership is to produce more leaders, not more followers.” – Ralph Nader


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