China’s foreign exchange reserves have kept sliding since mid-2014, after deducting the foreign trade surplus.
In addition, the country has witnessed a continuous net outflow of capital since the third quarter of last year.
As of late August, nearly US$1 trillion has fled from China.
To makes things worse, the recent devaluation of the renminbi has triggered a rational expectation that the Chinese currency will be weakened further, which has accelerated the capital outflow.
That has been reflected in falling deposits of yuan in Hong Kong and the recent capital injection by the Hong Kong Monetary Authority.
China might face a further liquidity crunch if it fails to stem the huge capital outflow.
Without considerable monetary easing, China could experience a credit crisis like the 2008 global financial crisis and the 2011 eurozone debt crisis.
So, how might Beijing fence off the risks stemming from the slowdown in economic growth and a credit crunch?
There are three main options.
First, Beijing should continue to adopt further monetary easing measures, such as cutting interest rates and the reserve requirement ratio, as it did in the year’s first six months.
It remains unclear whether the Chinese central bank will adopt a more aggressive approach.
Beijing pumped 4 trillion yuan (US$630 billion) into the economy to stimulate growth during the 2008 financial crisis, and there was no capital flight.
Instead, massive amounts of capital flowed into the country.
That is to say, China was “printing money” in a controlled manner back then.
But the aggressive monetary easing has driven up the ratio of non-financial institutions’ debt to gross domestic product to a record high of 1.93 times, exceeding the peak level of 1.7 times in the United States at the height of the financial crisis.
China’s debt ratio is close to Japan’s level of 2 times GDP in the early 1990s.
Hence, a credit bubble is already looming in China.
If Beijing again launches massive monetary easing, it would create huge instability for the economy or even society at large.
That is the last thing Beijing wants to see.
So any massive monetary easing is quite unlikely.
Second, sell US treasuries.
Beijing might sell its holdings gradually in response to the capital outflow and falling foreign exchange reserves.
However, the amount and pace of the sell-off might exceed market expectations.
China has kept its holding of US treasuries at about US$1.2 trillion in recent years, and the Chinese central bank has reportedly started reducing its holdings through the Belgian central bank since early this year.
Third, weaken the Chinese currency by over 10 percent.
The market has already formed a rational expectation after the recent one-off devaluation of more to come.
The US dollar may post a second rally if the Federal Reserve announces a rate hike at its meeting later this month.
That would further weigh on the Chinese currency and lead to a greater outflow of capital from China.
In that case, Beijing might execute a real one-off devaluation by allowing the redback to depreciate by about 10 percent, in an attempt to avert a cycle of devaluation in future.
Nevertheless, the equity market posted a strong rebound in recent days.
Was that a sign that the key issues that global markets are concerned about have already been fixed?
The risk of a credit crisis in China still looms following massive capital outflows, given that the market still expects further strength in the US dollar and moderating growth in China.
Global financial markets will remain very volatile in coming months.
Investors have to be vigilant when betting on short-term rebounds.
This article appeared in the Hong Kong Economic Journal on Sept. 10.
Translation by Julie Zhu
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