China property bubble, carry trade and all that

Interesting comments from the GaveKal research group (see here and here for more). They're forecasting a strengthening dollar, no renminbi revaluation and a weakening euro. Looks like an interesting multi-lingual group of analysts with a lot of HK experience.

...all of our work has constantly drawn up the same conclusion: in the past couple of years, Asian central bank reserves have grown much more rapidly than domestic current account surpluses and foreign direct investments; in recent years, Asian countries have managed to save more than they have earned. Last year, in China, the difference was some US$80bn... or nearly 6% of Chinese GDP.

This, of course, begs the question of where this money came from? The answer, we believe, is simple enough: the excess US$ that have showed up in central bank reserves represent borrowed US$; not earned US$. A quick example: in 2003, most of the simpletons who sit in the GaveKal HK office became convinced that the RMB was set to revalue. To cash in on this one time bonanza, a "get-rich quick" scheme was put together: the first step involved purchasing real estate on the Mainland (one of the few RMB denominated assets easy for foreigners to purchase). The second step involved securing mortgages on the property denominated in US$. The end result was clear: a US$ liability attached to a RMB asset. Elementary my dear Watson...

So elementary in fact that, as the rumors of a RMB revaluation accelerated, everyone and their dog got in on the trade. And before we knew it, we faced a) a massive construction boom in every Chinese city (hereby depressing rental yields) and b) a growth in the PBoC's US$ reserves that had nothing to do with either trade or direct investment flows and everything to do with speculative leverage.

With an economic slowdown unfolding in China, a revaluation becoming increasingly unlikely, a rising US$, rising US interest rates, and Chinese companies lining up to get money out of China, a number of participants (from Taiwan, HK, Singapore, Indonesia....) in the above real-estate/RMB trade might start to re-think whether the above trade is as one-sided as it appeared two years ago. If they conclude that it isn't, some will sell, turn their RMB to the PBoC and ask for the US$ back to re-pay the bank. Now obviously, the PBoC is swimming in a sea of US$. So it will have no problems meeting that demands for reimbursement. But as it reimburses, the Chinese money supply will shrink. Unless, of course, the PBoC allows the RMB to fall, which, given current political circumstances is unlikely.

The extent by which the Chinese money supply will shrink could well end up being dictated by the extent to which the PBoC has engaged in "reserve diversification". Indeed, if the PBoC has used the "borrowed US$" to buy Euros, AU$ or Yen, then as speculators come forth and ask for their US$ back, the PBoC will be in a bind. It will need to cash in the speculators demand, and sell Euros or Yen at the same time to make sure it maintains enough US$ to defend the RMB peg.

Needless to say, the operation of the PBoC are very opaque, and we have no idea the extent to which they have engaged in reserve diversification. But we know more or less what the Hong Kong Monetary Authority has been up to; our friend David Scott writes: "the HKMA might have cut its US$ holdings to around 70% of total reserves. This is very bullish for the US$. The HKMA has a 100% Dollar target for its currency. So now it faces a) rising US interest rates relative to other currencies - so relative yields on its investment portfolio will be suffering. b) Rising HK rates relative to Euro rates ie the cost of its liabilities will be rising relative to the yield on its assets. c) a partial currency mismatch. We believe the unwinding of the US$ carry trade will affect Asia disproportionately; especially countries with pegged currencies (HK, Malaysia, China) which will be unable to cope with the unwinding of the US carry-trade by allowing their currencies to weaken (something Japan and Thailand are already doing).