The reason for this call, according to the bank is the level of capital outflows currently ongoing.
“China’s reserves have already fallen by $663bn from mid-2014, and a further decline of this scale would start to severely impair the Chinese authorities’ ability to control the currency and mitigate future balance of payments crises,” the bank says, adding: “We estimate that if capital outflows maintain their current pace, the PBoC would be unable to defend the yuan for more than two to three quarters.
While it says resident flows have been primarily responsible for the recent capital outflows and continue to pose the biggest risk to the status quo, the potential scope of non-resident outflows is not trivial.
“The path to our risk scenario of USD/CNY 7.50 could take various forms, but most likely would entail moving to a free-floating FX regime within six months after depleting FX reserves by $150bn per month for two quarters due to persistent capital outflows and failing to sufficiently tighten capital controls.”
Frenzied speculation
This is why Sunday’s announcement is of interest. In the greater scheme of things it can be likened to a report from a surgeon on whether or not a tourniquet is holding and for how long the capital haemorrhaging can be held at bay.
SocGen strategist, Albert Edwards, agrees with the bank’s cross asset research and adds that, while China’s high FX burn rate is well known, as they currently sit at $3.2trn, the market is of the view that “massive firepower remains to support the renminbi.”
But, he says, this is not the case: “Our economists estimate that when FX reserves reach $2.8 trillion – which should only take a few more months at this rate – FX reserves will fall below the IMF’s recommended lower bound. If that occurs in the next few months, expect to see a tidal wave of speculative selling, forcing the PBoC to throw in the towel and let the market decide the level of the renminbi exchange rate.
“The market is likely to become increasingly transfixed by both the rate of decline in its FX reserves and with the approach of the key $2.8 trillion level. Even in the absence of actual currency weakness, any further large falls in reserves will only generate additional selling pressure in a frenzy of speculation of an imminent devaluation,” he added.
Anyone hoping for a calmer ride over February than they saw in January is likely to be disappointed, as even the words ‘frenzy of speculation’ are liable to push the VIX up. But, there are also longer term issues to worry oneself with. As China’s currency weakens, so fears that its cheaper exports will ‘steal’ growth from other countries particularly in other, even more rickety emerging markets will likely grow. And, with it, their ‘humiliation’.
