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The Risk of Capital Flight
But even before the news about PCAOB, an obscure set of data released by SAFE went largely unnoticed by the market. According to the release from SAFE, the surplus of FX balance of bank settlement and sale on behalf of clients had declined to its lowest since last April, affected by a large fall in goods trade (
Figure 2
). This is a prelude to further slowdown in China’s exports growth. And we have flagged this likelihood in our last report “
An Oversold Reprieve: How Far will it Go?
” published on 2022-03-21.
In our 2022 outlook report titled “
The Shadow Fed Tightening
” (2021-11-15), we outlined our macro framework of using the change in macroeconomic accounts to measure the production-consumption relationship between China and the West and to forecast the market this year. We posited that Chinese exports growth will likely slow this year. And the accumulation of forex reserve both in the PBoC and China’s commercial banks has been an important source of liquidity for Chinese stocks, and has been moving in tandem with the Chinese markets.
Figure 2: The change in FX balance sold & settled on behalf of clients suggests capital outflow
Source: Bloomberg, BOCOM Int’l
The balance of FX settlement and sale of banks on behalf of clients is traded and settled in the interbank forex market. As such, it is one of the important sources of China’s forex reserve, and can affect market liquidity. In
Figure 2
, we compare the change in FX settlement and sale balance with the Shanghai Composite. Even to the naked eye, a close correlation between these variables is palpable.
Even more alarming is the USD balance of the Capital and Financial Account. For the first time since February 2021, the securities investment account under the capital account registered a substantial capital outflow, and its magnitude is even larger than the outflow in March 2020 (
Figure 1
). Such significant movement in the capital account should have raised many eyebrows, and is an indication that foreign investors may be bailing out the market in droves. Yet, it took the market more than two days to realize this important development, after being shocked by the PCAOB’s statement.
Not surprisingly, the change in the capital and financial account has been moving in tandem with the China market indices. Outflow of such magnitude hints at the risk of capital flight. While the outflow is equivalent to that at the depth of the pandemic, the challenge that China’s markets are facing is of a different nature. The virus will be defeated eventually, yet the fate of Chinese companies being delisted from the US exchanges may be irreversible, as discussed above. As such, one cannot be sure whether the outflow has reflected the confidence panic and thus seen its worst.
For now, we would tiptoe on the safe side.
Global Macro Risk: the US Long Yield
Breaking its Secular Trend
As the Fed starts to hike and is set to hasten its tightening pace, the BoJ announced another round of QE. The yen weakened substantially, well beyond its long-term trend. The yen has been an important funding currency for carry trade of risk assets (
Figure 3
).
Figure 3: The yen’s significant weakness is diverging from the Shanghai Composite
Source: Bloomberg, BOCOM Int’l
Historically, when the yen’s weakness was at its current level or worse, the Shanghai Composite tended to be stuck, or peaking soon. If the yen’s weakness is a risk-on indicator and is approaching its extreme, then the momentum in risk assets such as the Chinese markets will wane in tandem.
The Japanese retail investors seem to agree, and is betting against the yen’s weakness. Of course, no indicator, including the legendary Japanese retail investors who have earned an enviable place in global macro trading, is infallible. But we should heed their bets against an apparent conclusion of the yen’s weakness against a backdrop of diverging Fed and BoJ. After all, many macro correlations have been destroyed since the epic easing by the Fed two years ago. Last Thursday, 24 March, was the two-year anniversary of the market nadir during the pandemic.
The US 10-year yield has surged past its secular downtrend. The 10-year has traversed numerous global crises and recoveries since the 1960s. The peaks of the yield in the secular downtrend suggest a significant tightening of the USD liquidity and correspond to crises somewhere in the world. And the troughs of the yield bring liquidity reliefs and global recoveries (
Figure 4
).
The only time in decades when the 10-year pierced the secular downtrend significantly was in late 2018 when Powell put monetary policy on “autopilot”. At that time, the US market plunged into its “worst Christmas since the Great Depression”. Now, with inflation at 8% and rising, the Fed has no choice but to press on with its hikes.
Figure 4: The 10-year is a history of global crises and recoveries
