In guiding the renminbi into its steepest dive since 2005 this week, Beijing was employing a strategy of “one arrow, two vultures”, as the saying goes.
The first vulture denotes the international speculators who have – in spite of warnings by Chinese officials – regarded renminbi appreciation against the US dollar as a one-way bet. The second vulture signifies the domestic shadow financiers who refuse to be brought down to earth.
Neither of Beijing’s avian quarries is dead or even mortally wounded, but the renminbi’s surprise decline will have ruffled plenty of feathers. More importantly, it serves notice that China is opening up a new front in its battle to reduce risks in a highly volatile financial system.
It takes a little detective work to unravel how guiding the renminbi lower helps China manage financial risks because it involves a vast twilight zone of financial dealings for which there is little data, official or otherwise. Nevertheless, it is the dealings in this zone – which includes domestic shadow finance and irregular cross-border capital flows – that are increasingly setting the tone for Beijing’s policies.
The story starts with the People’s Bank of China’s repeated failure to bring shadow finance to heel. Since the announcement of Document 463 in December 2012, authorities have been turning up the pressure on shadow finance, mainly with the aim of preventing high-interest trust loans from triggering defaults among local government borrowers. But official statistics show that such efforts have not yet borne fruit. Entrusted loans rose to Rmb396.5bn ($64.7bn) in January, almost double the levels of the same month a year ago.
Worse than this failure, though, is evidence that the PBoC’s policies may be backfiring. Dodging the central bank’s pressure to liquidate shadow financial assets (which offer attractive returns), banks are opting instead to sell off lower yielding enterprise bonds (debt issued by state-owned companies), thus raising the cost of financing to companies and local governments, according to research by China Confidential, a research service at the Financial Times.
While this squeezes the supply of credit to the “real” economy, the shadow finance segment is nourished by inflows of capital that gush through a hundred holes in China’s nominally “closed” capital account.
A shadow banker in Ningbo, eastern China, recently described the attractions of such a trade. “It is easy to borrow abroad at around 1 per cent annual interest. Then change that money into renminbi and bring it into the mainland,” said the banker, who declined to be identified because of the illegal nature of his business.
“You can get around 10 to 12 per cent by lending it to a trust or around 20 per cent by putting it with an underground bank. On top of that you get whatever the renminbi has appreciated by the time you need to repay the foreign loan.”
One sign that this cross-border carry trade has been robust of late is evidence of an increase in the over-invoicing of exports, a common ruse used to spirit funds into the mainland. A China Confidential survey of exporters in January found that 44 per cent of respondents thought that such fake invoicing was on the increase.
Besieged by these pressures, it is hardly surprising that the PBoC was keen to shoot an arrow. Its hope is that by instilling in speculators’ consciousness a sense that the renminbi can fall as well as rise, it will staunch the inrush of speculative capital lured by the outsized returns available in the mainland’s shadow finance markets.
In this, as ever, Beijing is looking for incremental shifts, such as the 1.2 per cent that the renminbi has depreciated by so far this year. It knows that if it were to try to stop the inflow of illegal capital entirely, it may trigger the very wave of financial defaults it is hoping to avoid. Thus a gradual approach using exchange rate flexibility to generate a market response seems to suit the PBoC’s objectives for now.