Another $700 Billion Potential Capital Flight Threatens China’s Red Ponzi

By SUE CHANG at Marketwatch

In yet another sign of deteriorating confidence in China’s economic prospects, capital outflows from the country are accelerating quickly, adding another layer of worry for investors and policy makers alike.

“If all of the capital that went into China since 2010 were to exit, this would mean another $400 billion could leave. If we were to assume that all of the capital inflows that went in since 2008 were to exit, the number rises to another $700 billion,” said David Woo, FX and rates strategist at Bank of America Merrill Lynch.

While Woo’s projections are based on the worst-case scenario, analysts at Goldman Sachs in July had noted the alarming pace of funds exiting the country.
“Net capital outflows could be around $224 billion in the [second] quarter, meaningfully up from the first quarter,” they said. “Capital outflows have become very sizeable and now eclipse anything seen in the recent past.”

In theory, China’s foreign exchange reserves of $3.6 trillion are sufficient to handle the capital flight, but Woo believes Chinese officials are running out of tools to prop up the economy, forcing them to make a tough choice.

“China cannot lower interest rates and defend the Chinese yuan at the same time,” he said. And once the Federal Reserve hikes interest rates, which BAML still expects this month, the interest rate differential between China and the U.S. will further narrow, leading to more capital leaving the country, he said.

Chart illustrates how interest rate differential affects capital inflow.
As a result, Beijing is expected to curtail foreign-exchange interventions and allow the yuan to fall further in an effort to keep its monetary policy options open. This could lead to a fresh currency war, particularly among emerging-market countries, but it could also pave the way for additional monetary easing and attract

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