From Tyler Durden at zerohedge.com:
Last week, in “What China’s Treasury Liquidation Means: $1 Trillion QE In Reverse,” we took a look at the potential size of the RMB carry trade, noting that according to BofAML, the unwind could, in the worst case scenario, be somewhere on the order of $1 trillion.
Extrapolating from that and applying Citi’s take on the impact of EM reserve drawdowns on 10Y UST yields (which, incidentally, is based on “Financing US Debt: Is There Enough Money in the World – and at What Cost?”, by John Kitchen and Menzie Chinn from 2011), we noted that potentially, if China were to use its FX reserves to offset the pressure on the yuan from the unwind of the great RMB carry, the effect could be to put more than 200bps of upward pressure on the 10Y yield.
Going farther, we also said that $1 trillion in FX reserve liquidation by the PBoC would essentially negate around 60% of QE3. In other words, China’s persistent FX interventions amount to reverse QE or, as Deutsche Bank calls is “quantitative tightening.”
Now, SocGen is out with a description of China’s “impossible trinity” or “trilemma”. Here’s the critical passage:
The PBoC is caught in an awkward position: not letting the currency go requires significant FX intervention that will not prevent ongoing capital outflows but which will result in tightening domestic liquidity conditions; but letting the currency go risks more immense capital outflow pressures in the immediate short term, external debt defaults and possibly further domestic investment deceleration. Furthermore, it has to consider the painful repercussions globally that could result from any sharp RMB depreciation.
In other words, because the new currency regime looks to have paradoxically created a situation where the market will play less of a role in determining the exchange rate for the yuan, China will be stuck liquidating its reserves and offsetting that resultant liquidity drain with reverse repos, RRR cuts, and a mishmash of short- and medium-term lending ops which, to the extent they’re seen as net easing, will only exacerbate pressure on the yuan, necessitating still more interventions in a very non-virtuous loop until such a time as the PBoC either runs out of assets to sell or else throws in the towel and moves to a free float which would likely trigger an all-out short-term panic.
To continue reading: How China Cornered The Fed
