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JA N UAR Y 2 0 1 5
S T R I C T L Y C O N F I D E N T I A L
N O T F O R D I S T R I B U T I O N
+1 203 569-7743
China & EM, here we go again...
Slide 3: China: Capital Outflows the Critical Fragility
Slide 4: Closed Capital Account + Current Account Surplus does NOT Protect Against Crisis
Slide 5: Global Currencies vs USD
Slide 6: What RMB Devaluation?
Slide 7: Asian Devaluations in 1997/98
Slide 8: China Carry Trade Dynamics
Slide 9: Hidden ‘hot money’ inflows
Slide 10: China FX Reserves & Sufficiency
Slide 11: China Base Money Dynamics
Slide 12: Why China Will Give up its RMB Defense
Slide 13: Why Not Just Enforce/Tighten Capital Controls?
Slide 14: Can China halt Disorderly Disruption?
Slide 15: What Can/Will Global Institutions Do?
Slide 16: How to Position for China Disorderly Disruption
Slide 17: How to Position (continued)
Source: St Louis Federal Reserve, China State Administration of Foreign Exchange
Devaluation in 71% of cases….China 4yr debt/GDP +49% 2009-’12; +75% 2009-’14…
USD has been in a major bull
market and appreciated strongly
against every non-pegged global
CNY has only devalued 8% from
its peak ( 6.05 RMB/USD in Jan
RMB devaluation allows China to
take back control of its Monetary
Policy and implement needed
easing, in addition to restoring
competitiveness lost over the last
years due to its USD quasi-peg.
CNY is still up about 27% since
September 2011 on NEER basis,
but the Reversal is clear, and in its
very early days…
Source: Morgan Stanley, Asia ex Japan Economics: A Comparison of the Current Cycle with 1997-98; August 24, 2015
Prior to 2014, the RMB had
extremely attractive Carry Trade
dynamics, resulting in the largest
Carry Trade in history (est. $2-3Tr)
‘Hot money’ inflows were hidden
in the Current Account (fake
exports) and Capital Account
(fake FDI), making exact
calculation of the size of the Carry
The RMB Carry Trade is now
reversing, adding to Capital
Outflow pressures. An estimated
$1-2Tr of the Carry Trade has not
been unwound yet.
Over $1Tr in ‘hot money’ inflows from 2009-2014 hidden in FDI and
overinflated exports to Hong Kong…These are just 2 of many channels
Under IMF FX reserves adequacy
definition, China’s minimum
prudential level of FX reserves is
$2.6Tr. China is less than $700B
away from that level.
Estimated $500B-1Tr of China’s FX
reserves are in illiquid assets (FX
loans to SOE’s; Capital injections
in policy banks; investments in
external entities, etc.)
China Household Bank Deposits
are 55 Trillion CNY ($8.4Tr);
‘Quasi-liquid’ WMP & Equity
holdings are around 30Tr CNY
Source: Citibank: EM Macro & Strategy Outlook; Aug 21, 2015
Capital Outflows destroy Base Money in China, which removes liquidity and increases market
interest rates, increasing pressures on the financial system and raising the risk of a full blown
Interest rate and RRR cuts by the PBoC have been fully neutralized by Capital Outflows (which
have taken Monetary Policy control away from China), and will continue to be ineffective until net
Capital flows balance again. Inflating monetary policy requires a much bigger exchange rate
Capital flows will only balance once the market believes no further sharp devaluation lies ahead and
that the RMB is trading at or near a ‘market equilibrium’ level
1. Capital Outflow Pressures (est. $930B - $1.3Tr+ from 2Q14-end-2015)
• Carry Trade Reversal is structural
• IF THESE CONTINUE, NOTHING ELSE MATTERS. It will not be about what China’s
leadership ‘wants’ to do, it will be about what they are ‘FORCED’ to do.
2. Domestic Liquidity Considerations & Monetary Policy
• RMB defense is destroying Base Money & tightening liquidity, increasing domestic pain
• China needs Monetary Policy flexibility, & lower Real Interest Rates
• Devaluation and letting RMB find ‘market equilibrium’ will make Monetary Policy effective
again as easing steps will no longer result in new liquidity immediately turning into more
3. Deflationary Pressures: PPI in deflation for 46 straight months
4. Prevent Debt-Deflationary spiral
5. Relatively low FX debt – around $1Tr – means limited pain
6. Lower RMB will support (CNY denominated) Domestic Equity market
7. Restore Lost Competitiveness
8. Encourage resumed gross Capital inflows & balanced net flows
1. China needs Gross inflows to resume. Reversing course on Capital Account
openness will send the wrong signal to the market and discourage inflows
2. Investor confidence will likely be severely damaged if China backtracks on
Capital Account openness and renews Capital controls, as this will be a clear signal
of loss of control
3. Capital Controls unlikely to work anyway. Successful uses of Capital Controls
(Malaysia 1998, Iceland 2009) – Capital Controls were imposed AFTER large
devaluations (48% at the trough in Malaysia, eventually stabilizing at 35%; over 50%
• Similar to different effectiveness of Hong Kong Gov’t stock rescue in 1998
(successful – HK Gov’t bought after collapse), and China Gov’t stock rescue in
2015 (unsuccessful – China Gov’t bought too early trying to prevent a collapse)
4. Capital Control attempts fail, and result in increasing Capital outflows and
ultimately devaluation, after burning through capital that would have been better used
to support economic recovery.
All of China’s potential policy responses come with costs. There
are no ‘painless’ solutions
Strong Currency defense, maintain gradual depreciation
1. Capital outflows will continue and likely accelerate
2. Domestic Liquidity will continue to tighten
3. Monetary Policy easing will continue to be ineffective
4. No help for heavily indebted, heavily overcapacity Corporate sector
Allow RMB to “float”
1. “Front running Capital outflows” stop
2. China regains control of Monetary Policy
3. Corporate sector restores some competitiveness
4. Deflation likely turns to inflation, helping with crippling Corporate debts
Lessons from Previous crises – 1997 Asian Financial Crisis, early 1990’s
Nordic crisis, 1992 UK deval, 1990’s (and ongoing…) Japan - are clear:
• Devaluation can be a critical and necessary component of recovery
• Devaluation is not a “cure all”, but it is part of the adjustment process
Globally coordinated action by Central Banks, Governments and
• Politically impossible BEFORE crisis. Even if there is a “bailout
package”, or new global Currency regime, it will not happen before
there are sizeable losses across assets
• Same with US Fed reversing course
• China too important to allow to fail? So was Russia in 1998….
• Impact on Confidence: Will investors embrace QE4 as they did the
previous versions, or will this be the “Emperor’s Clothes” moment?
Geopolitics are much more poisonous now than they were in
2008, 1997, 1994, 1991……
• US Presidential election, UK EU Referendum, Taiwan election
• During previous crises, there was significantly greater political stability,
US Economic power and policies were unquestioned and all of the
recipient states had friendly relations with the US
Expect RMB to fall 20%+ vs USD (to 8.0+) This would be a ‘Reset Event’
Globally: All forecasts for Inflation/deflation, Interest Rates, Currency
crosses, Growth, Commodity prices would have to be ripped up.
There is no place to hide in EM…1997-98 type crash probable…China
today is 1.6-2x the size Asia ex-Japan was in 1997 as % of global GDP
1st derivatives of China (commodities & commodity exporters) have already
had substantial losses, as have 2nd derivatives (currencies of commodity
exporters, EM Equities, EM focused Asset Management, MNC’s with heavy
China exposure), but 3rd and 4th derivative trades are early in their
corrections. High beta assets at historically high valuations (Hong Kong
property….) face major corrections
Investor liquidation from EM will indiscriminately hit all EM risk assets, even
those that do not sell to, or compete with China (i.e. India)
DM Risk assets all vulnerable too. US$ and US Gov’t Bonds may be the
only ‘safe havens’.
Tail Risk trades
• Correlation & Volatility trades
• ‘Best-of’ put options
• Low delta, deep ‘out-of-the-money’ puts. Avoid spread trades
What are the Peregrine’s and Lehman’s today?
• Dependent on Wholesale market liquidity
• Long the Wrong Assets: Carry Trade, Commodities, China, EM
• Beware Counterparty Risk!! Avoid Asia & EM focused counterparties
When will it be time to get Long Again?
China is the Epicenter of stress in EM and Commodity markets, and a prime
contributor to DM uncertainty. EM & Commodities will not hit bottom until
China’s disorderly disruption is resolved, which requires some combination of:
Devaluation (extremely likely), systematic Debt restructuring (already started,
but very early in the process), ‘sane’ Equity valuations (ongoing). Only
AFTER this, and the associated capitulation out of EM, should EM present
another “once-in-a-generation” investment opportunity….
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