ZUGZWANG: 'China arguably has 6 to 12 months before FX reserves fall below comfort levels'

The long, grinding economic slowdown in China is coming to a head, and the country has entered a "zugzwang," according to Barclays analysts Ajay Rajadhyaksha and Jian Chang:

In chess, the concept of zugzwang refers to a point in the game where any change in the status quo weakens a player's position. The ideal choice would be to not make a move, except that "pass" is not an option.

This concept effectively explains the choices that confront China's policy makers, who will have to make a decision about the country's currency and monetary policy in the next few quarters. None of the choices are terribly appealing, and all carry risks for financial markets.

That decision - whether to move interest rates, manipulate the value of the renminbi, or stop printing money - is being forced by the declining base of China's foreign currency reserves (the foreign money its central bank uses to trade its own currency and bonds, and that of other countries).

This is how fast China's reserves have gone down recently:

• China's reserves declined by $500 billion in 2015.
• They now sit about $750 billion below their 2014 peak.
• Reserves declined by about another $300 billion in the last three months.
• Currently, reserves are about $3.2 trillion, according to Barclays.

"China still has $3.2trn in FX reserves, which is a very large number. However, it is not infinite," the Barclays analysts say.

China's economy is so massive that if only 4% of Chinese were to move $50,000 out of the country in a single year (for instance, to protect it from devaluing as the RMB collapses) then "the hypothetical capital outflows would theoretically wipe out the entire remaining stock of foreign reserves."

That scenario is unlikely, Rajadhyaksha and Chang say, because it would require the People's Bank of China to adopt a suicidal defence of the RMB that would trigger a run on the bank until its FX reserves hit zero. However, it is plausible that China's reserves might continue to deplete as capital flees the country, bringing China nearer to the bottom of the "cushion" that reassures everyone that China can still defend its currency if it needs to. That "cushion" isn't very far away, they say:

The IMF has developed a formulaic approach to estimate a safe level of a country's FX reserves. Based on that, a safe level for China is USD2-2.75trn (Figure 7). We do not know the level of FX reserve decline the PboC is comfortable with; perhaps the answer is $2trn or perhaps it is $2.5trn. Our point is that most of the $3.2trn is not pure "cushion." If we are right that the pace of money creation is driving capital outflows, there is no reason to expect outflows to suddenly slow down; we believe further outflows are "baked in the cake." At the current pace of FX reserve decline, China arguably has six to 12 months before FX reserves fall below comfort levels.

China has three options for dealing with this, none of them good. (Hence the zugzwang.)

• The PBOC could enforce capital controls, preventing Chinese from moving money abroad. That type of solution is very rare and very unpopular, and likely not the bank's first choice.
• China could tighten its interest rates upward. But that might hurt the economy and trigger a crisis anyway, because "when credit conditions tighten, defaults often jump exponentially," Barclays says.
• China could allow the RMB to depreciate in moderation, to signal to investors that the currency has reached the bottom of it valuation and thus encourage investors to buy it, given that increases would appear to be coming in the future. But that policy might exacerbate capital flight as long as investors continued to believe the RMB was not in fact hitting bottom, but still had a way to go.