China Rate Cut: Unintended Consequence

Summary
China announced interest rate cut of 25 bases points during the weekend after recent disappointing macro-economic data. There is hope that the easy monetary policy can help China reverse the slowdown.  However, the rate cut may have unintended consequences. Since 2008, there has been a pattern of US dollar flowing into China through carry trade. This source represented an important part of the liquidity to the local market. But the whole carry trade is based on an unsustainable system. Further rate cuts in China and possible hikes in US later this year will risk pushing carry traders to disorderly wind down their positions.

Carry trade is an important part of liquidity in China
Since the financial crisis in 2008, China has increased its foreign exchange reserve by around USD2.5tn, among which trade surplus contributed USD1.8tn. There has been a lot of comments about the fake trade which helped investors move money into China. No one knows the exact number of the carry trade and some analysis even suggested that it may be over USD1tn. But at least two indicators can help put some light on this issue. Since 2010, accumulated difference between reported China export to HK and HK import from China has amounted to over USD400bn. Another indicator is Hong Kong banks’ total international claims which also increased by around USD300bn. Mainland companies can use off shore entities and complicated structures to bring trade finance into China. Although there is some double count here, the total amount can be easily above USD500bn and it has not counted any other source of money flow.

An unsustainable triangle
For the carry trade, when US dollar moved into China, the real dollar became currency reserve for central bank while RMB was issued for investors to buy wealth management products. Most of the money ultimately went into property and infrastructure projects. As long as there is liquidity, the products can always be refinanced:
Figure 3: Carry trade system

Source: Estimation

However, the system was based on three basic assumptions: interest rate difference, stable currency and return on (of) the projects. While the system has been running for five years, it becomes partly self-fulfilling. Wave after wave of incoming money, supplied by US central bank, guaranteed a rising currency and easy refinance of even the worst projects.

Interest rate difference: The rate to borrow the US dollar in Hong Kong was around 2.5% for companies in China and they can easily reinvest the money into wealth management products that yield 6% and the products were implicitly guaranteed by government. The rate difference has been constantly around 3% or higher which created a perfect environment for the carry trade.

Stable currency: Besides the self-fulfilling effect from more money coming in, investors also have some kind of belief that Chinese government will let the currency gradually rise in the foreseeable future. Because since 2005, the trend of ever rising currency has been the case. A lot of carry trade investors did not even bother to hedge the currency and enjoyed extra gains from the currency move.

Return or refinance of the projects: Nowadays, it was rare for a wealth management product to return cash when it is due because of the project had made money and cash flow. Almost all of the products were refinanced by another one. A lot of the money ultimately went into the property and infrastructure projects that may never make money. But the investors believed that they will not be the last one to hold the products or government will save them from any problems.

Rate cut and death spiral
The whole carry trade system was very attractive to investors because it did not require a lot of initial capital. It was like making money out of thin air. But it is completely wrong to think that the system can be sustainable. The Chinese rate cut and possible US rate hike may put enormous pressure on investors. The intention to ease the monetary policy is good but the combination of policies may quickly kill the carry trade investors. When everybody runs to cover the trade, currency will be under pressure, the bad projects will run out of money and the selling of assets by central bank will further squeeze the interest rate difference and currency.
Figure 4: Interest rate difference between 2 year Chinese government bond and US treasury
Source: Yahoo finance

Conclusion
The only thing that can prevent the breakdown is central bank’s USD3.8tn reserve and market believes that the worst consequence can be avoided. That may be the case but the whole system is still not sustainable in the long term. It is amazing how easy money and ‘implicitly-guaranteed-by-government’ assets can distort the market and lead people to invest in low return projects and ever rising properties. But the reverse of the process will be very painful. If central banks in China and US resume their course, we may see the crisis sooner than we thought.