Looking at market history, it seems that every time the yuan weakens sharply, the issue of capital flight, or the movement of money out of China, resurfaces. But, why is this?
By any measure, China is a heavily indebted economy, on par with other indebted developed markets and much more than the average emerging market country. Interestingly enough, the fear with China isn’t the typical EM crisis where the country has large USD liabilities without the ability to print USD. Instead, the fear stems from China’s aggressive yuan-denominated credit expansion that has led to a misallocation of resources which then leads to non-performing loans.
Yet despite many warnings over China’s debt excess, the country has been able to avoid system-wide issues. Part of the explanation for this has to do with hesitation from lenders to write off bad loans. Instead, the lenders tend to “evergreen” the loans, meaning that the bad loans appear as small drags over multiple periods. This results in a slowly deflating bubble as opposed to a bursting bubble.
However, this only works as long as banks have no funding issues, which they usually don’t given the very high savings rates for Chinese households. This is why markets are so spooked by Chinese capital flight. In essence, a large scale desire from domestic savers to move money abroad is China’s Achilles heel.
To be clear, we have not seen any signs of capital flight, however the interbank market remains less than 1% away from the psychologically important 7 yuan per 1 USD level. This is the level that news reports suggest the PBoC will defend, and should it be breached, market sentiment could change.
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