I was bearish on Macau casinos throughout 2011, viewing them as a conduit for money laundering as well as a temporary beneficiary of the credit and liquidity explosion in 2009/10, noting in February last year that: ‘A lot of official statistics on the Chinese economy are at best of dubious quality, but casino revenues for Macau are reliable and the trend is worth watching closely. On a back of the envelope calculation of average casino margins the total cash wagered by Chinese gamblers must be in the order of $750-800bn, from an economy which officially had nominal GDP in 2010 of $5.7trn…the activity of Chinese high rollers in Macau is also a useful leading indicator of domestic liquidity conditions and I would keep a close eye on trading in those casinos as much as money market rates.’ That insight remains valid, and those liquidity conditions are de facto being tightened by rising capital outflows, as much as weak bank deposit growth.
With restricted corruption opportunities for mainland officials from land sales as real estate investment slides, a squeeze on the shadow banking system since early 2011 as well as growing political pressure to ‘tone down’ conspicuous consumption, fewer have been making high-roller trips to Macau and the tough junket market can’t be replaced by a still healthy mainstream tourist market. After surging 58% in 2010 and 42% in 2011, gross gaming revenue growth looks to be slowing to 12% this year and at best half that next. Gross gaming revenue growth was 12% y/y in June but softened to just 1.5% in July, and gaming activity is correlating with high-end retail activity in both China and HK. As in retailing, it looks wise to concentrate any exposure on the mass market players, because the VIP squeeze will worsen in coming months as the political mood shifts further, and overall growth in VIP revenues for 2013 may well struggle to be positive.
In expectation of RMB weakness, Chinese companies have been accumulating dollars at a record pace this year and total foreign currency deposits have increased $137bn, or 50%, since January. However, reduced flow of funds into China’s financial system mean inherently tighter conditions in money markets, making it more difficult for banks to make loans, and frustrating Beijing’s attempts to boost economic momentum.
This week, the PBoC injected a net RMB 278bn into the interbank money market, the largest net injection since early January. The overall monetary/credit backdrop remains subdued; M2 money supply increased by 13.9% y/y in July while M1 narrow money was up just 4.6% y/y while currency in circulation increased by 10%. RMB deposits are also falling again; total bank deposits fell by RMB500bn compared to the end of June, and both deposit growth and the reversal in capital flows are both acting as constraints on the default bank credit driven response to a cyclical slowdown in China. This is apparent in the lending figures; new lending to non-financial corporations was RMB358.8bn in July, down from RMB644bn in June of which only RMB92bn was in medium/long-term loans likely to result in real economic activity, while RMB152.6bn came from bill financing.
I covered the complex mechanics of Chinese monetary policy in a monthly note last November, and noted that a key element of money creation arose from weak FX sterilisation of sustained current account inflows via the RRR, which leaked into the real economy via the shadow banking sector; recent outflows imply that this money creation process has gone into reverse, tightening liquidity. What I underestimated then was just how fast reserve accumulation would slow in H1, as capital flight became a significant factor. RRR reductions and repo operations do not necessarily represent net easing when the capital account is seeing accelerating outflows and the RMB is declining in nominal (if not real effective) terms. From a stance of buying dollars and selling RMB sterilised via the bill market back to exporters over the past decade, the PBoC now has to sell USD to the market amid a domestic shortage, and surging demand for foreign currency deposits. That changes the liquidity dynamics within the economy fundamentally.
China’s trade surplus and FDI inflows mean pretty constant inflows of foreign funds into the economy, but the pace of growth has slowed dramatically. In the past, expectations that the RMB would rise meant those funds were rapidly exchanged. Purchases of foreign exchange that fall below monthly inflows from trade and investment suggest either hot-money outflows, or a decision by firms to hold their foreign earnings in dollars. The country’s banks were net sellers of 3.8bn RMB in July, from net buyers of RMB 200-400bn a month for most of 2011 i.e. local bank foreign exchange purchases are lower than the monthly trade/investment inflows, and it confirms anecdotal evidence that exporters are reluctant to settle in RMB. China’s banks have been sellers of dollars in five of the past 10 months, purchasing just RMB 145bn in FX over that combined period, compared to the RMB 905bn that flowed into the country via its cumulative trade surplus. To put that in context, in Jan-Oct 2008, China’s banks were net purchasers of RMB 3.6trn in FX and massive inflows of capital were a key factor behind China’s soaring bank lending, property prices and consistent RMB appreciation. The balance of payments deficit in Q2, the first since 1998, reflected these new and potentially structural trends.
The capital outflows so far represent only a minor reversal viewed against the over $3trn in FX reserves, and SAFE won’t be a forced seller of its vast stock of US Treasuries just yet. The flow trend has been negative since September 2011, but the overall FX position hasn’t changed much in the past year, standing at RMB25trn, ex FDI flows (which are down almost 9% y/y). Inflows of foreign money into China have slowed this year, despite the QFII scheme being more than doubled to $80bn but the key issue is that Chinese investors seem to be increasingly evading the country’s strict capital controls to send money offshore. The interesting question is whether those controls are tightened in response, or alternatively this ‘leakage’ accelerates capital account liberalisation.
Although the RMB’s real effective exchange rate index dropped only slightly in July on BIS calculations, from a record high of 106.49 in June, a significant nominal (say 2-3%) depreciation of the RMB in H2 would imply a degree of desperation, as well as complicating the US relationship and RMB internationalisation efforts. The PBoC will be attempting to manage a very gentle downward glide path for the currency, having struggled to stem its natural rise until recent months. As much as momentum in real estate prices and food inflation, the radical and on-going shift in China’s capital flows and consequently monetary environment will be a critical constraint on policy options. And it’s not great for the Baccarat tables either.