Morning Commentary: The Fright over Capital Flight

Foreign Exchange - Morning Commentary
The Fright over Capital Flight
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Markets have once again been rocked by trade concerns.  This time, tensions were due to comments from China indicating that it was not interested in continuing talks under the threat of more tariffs.  As a result, the Chinese yuan briefly moved to its weakest level against the USD since November.    
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.         
  • U.K. PM May has been forced, by members of her own party, to set a timeline for her departure as leader of the Conservatives.  Under the terms, PM May will get one more chance to pass her Brexit bill and will leave regardless of the outcome.  To this end, cross party talks have failed, increasing the likelihood that May’s deal will fail for a fourth time.  As it stands, PM May is expected to bring her bill to a vote at the beginning of June.  The GBP has fallen to its lowest levels since January as markets price in an increasing possibility of a no deal Brexit.
  • Banxico left interest rates steady at 8.25% as expected.  The tone of this meeting was mostly unchanged from March and the forward guidance remained solid.  High inflation (after removing transitory shocks) remains a primary concern and with the bank acknowledging and downplaying the drop in GDP, rate cuts appear unlikely near term.
  • Concerns over Italy have continued to pressure the euro as Deputy Prime Minister Salvini pledged to “tear apart every single European rule butchering Italy.”  With Italy’s fiscal outlook worsening, the risks of Italy facing disciplinary action from the EU are rising.
  • The U.S. officially confirmed that it will put off its decision on auto tariffs for 180 days, confirming news reports earlier in the week. 
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