China’s capital flight is continuing, with $108bn leaving in December alone, “and we are now rapidly approaching the $3 trillion level of foreign exchange reserves”, wrote Robin Parbrook, head of Asia ex- Japan equities, in a recent research note.
In addition to the capital flight, authorities are depleting foreign reserves by buying RMB and selling US dollars in attempt to defend the Chinese currency.
Parbrook warned that China is trying to run an independent monetary policy with a pegged exchange rate, which is the same contradictory strategy that caused the Asian financial crisis in the late 1990s.
“If the outflows continue, we think the consequences could be significant. The problems of an over-lent banking system and, in particular, a weak and overleveraged corporate sector will soon become apparent."
He added that policy flip-flops indicate that the authorities have few options.
"The end game looks increasingly clear – a more material fall in the renminbi is likely, significant bad debts will start to appear, and nominal GDP growth will be sub 5% (at best)"
“However, with equity markets in China off very sharply we have at last moved on from the false belief that many pundits in financial markets used to peddle that the authorities had some magic wand to make all the problems disappear.
“The end game looks increasingly clear – a more material fall in the renminbi is likely, significant bad debts will start to appear, and nominal GDP growth will be sub 5% (at best).
“We are likely to see further falls in A-share equity markets which still look very materially overvalued and we can in due course expect volatility in the Chinese bond markets both on and offshore.”
The warning echoes that of Kyle Bass, the founder of Dallas-based Hayman Capital, who has repeatedly said that China has a problem much larger than the 2008 subprime crisis (which he predicted and profited from).
Bass has argued that China’s dwindling $3trn in reserves are not enough to cover impending credit losses by the banking system and the consequences of that will have enormous significance for global markets.
Parbrook, however, does not forecast that China will undergo a “full-blown financial crisis".
He points out that China controls the banks and runs a large current account surplus. Central government debt-to-GDP is also relatively low and can therefore offset some bad debts.
However, he is staying out of China equities.
He finds opportunities in some Asian equities, which generally have lower valuations than last year. Parbrook has started to buy select blue chip names in Taiwan and Hong Kong in the technology and manufacturing sectors, which could benefit from a falling RMB.
“We remain cautious on ASEAN equities, however, where valuations in the main look high and earnings expectations are still unrealistic (consensus expectations are for an acceleration in 2016 earnings growth despite rising deflationary pressures and sluggish economies).”