China is perilously close to a devaluation crisis as the yuan threatens to break through the floor of its currency basket, despite massive intervention by the central bank to defend the exchange rate.
The country burned through at least $US120 billion of foreign reserves in December, twice the previous record, the clearest evidence to date that capital outflows have reached systemic proportions.
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Global shares tumble while oil prices slide to levels not seen since the early 2000s, after China allows the yuan to fall sharply again.
"There is certainly a sense that the situation is spiralling out of control," said Mark Williams from Capital Economics.
Mr Williams said the authorities botched a switch in early December from a dollar currency peg to a trade-weighted exchange basket, accidentally setting off an exodus of money. Skittish markets suspected - probably wrongly - that it was camouflage for devaluation. The central bank is now struggling to pick up the pieces.
Global markets are acutely sensitive to any sign that the China might be forced to abandon its defence of the yuan, with conspiracy theories rampant that it is gearing up for a currency war in a beggar-thy-neighbour push for export share.
Any such move would send a powerful deflationary impulse though a world economy already on its knees and risk setting off a chain reaction in Asia, replicating the 1998 crisis on a larger and more dangerous scale.
The confused signals coming from Beijing sent Brent oil crashing to an 11-year low of $US32.20. They have also set off a parallel drama on China's equity markets.
The authorities shut the main exchange after the Shanghai Composite index plunged 7.3 per cent in less than half an hour, triggering automatic circuit-breakers. The crash wiped out $US635 billion of market capitalisation in minutes. It was triggered by a witches' brew of worries: a fall in China's PMI composite index for manufacturing and services below the boom-bust line of 50, plus angst over an avalanche of selling by company insiders as the deadline neared for an end to the share-sales ban imposed last year.
Faced with mayhem, regulators have retreated yet again. They have extended the ban, this time prohibiting shareholders from selling more than 1 per cent of the total float over a three-month period. The China Securities Regulatory Commission said the move was to "defuse panic emotions".
The freeze on sales is an admission that the government is now trapped, forced to keep equities on life-support to stop the market crumbling. The commission said its "national team" would keep buying stocks if necessary, doubling down on its frantic buying spree to rescue the market last year.
Turmoil on the Shanghai "casino" has little bearing on the Chinese economy itself, which has been moving to an entirely different rhythm for years. Few companies raise capital on the stock market. A large chunk of the shares are owned by state entities, and are not traded.
The currency ructions are more serious. What is worrying is that the central bank has so far failed to stop the yuan sliding, despite spending an estimated $US140 billion last month in the foreign exchange markets.
Last month's switch to the currency basket (CFETS) was a belated move to liberate China from the rising dollar as the US Federal Reserve tightens policy. The view in Beijing is that the yuan is now fairly valued after soaring since mid-2012.
Premier Li Keqiang vowed to keep the basket rate "basically stable" yet it has been dropping for three weeks. It is hovering near a 16-month low. The spreads on offshore yuan contracts in Hong Kong have ballooned, a sign that traders are expecting worse to come. Events are coming to a head fast.
The central bank (PBOC) pinned its colours to the mast yesterday, insisting that it has the firepower to defeat "speculative forces" and keep the currency stable at a "reasonable equilibrium level."
It said the market gyrations had decoupled from the real economy and that a country running a current account surplus of almost $US600 billion has no need for a weaker currency. "It is not necessary to stimulate exports and stabilise growth through a competitive devaluation," it said.
For good measure, the authorities suspended the foreign exchange operations of Standard Chartered and DBS Group Holdings, and cracked down of false invoicing by exporters, effectively invoking police powers to stop money leaking out of the country.
China's reserves have dwindled from $US4 trillion to $US3.33 trillion and are no longer far from the $US2.6 trillion deemed to be the prudent threshold by the International Monetary Fund, given China's $US1.2 trillion liabilities. The central bank still has the clout for a shock-and-awe blitz to defend the yuan, but this entails serious costs. Reserve depletion causes monetary tightening. It is the exact opposite of the boom years when China accumulated reserves, causing the economy to overheat.
It can in theory offset this by cutting the reserve requirement ratio for banks (RRR) from 18 per cent to 5 per cent, where it was during the banking crisis in 1998. This would inject $US3 trillion stimulus, but would weaken the currency, accelerate the exodus of capital, and trap China in a vicious circle.
George Magnus from UBS said Beijing is trying to reconcile impossible objectives. "They don't want any tightening. They are trying to keep interbank rates as low as possible," he said.
In economic terms, it is the Impossible Trinity. No country can have an open capital account, a free exchange rate, and sovereign monetary policy. One must give.
In trade terms, China does not need to devalue, and it would not help much. The trade share of GDP has fallen to 41 per cent from 65 per cent a decade ago. Yet it needs internal stimulus to keep a hard-landing at bay, and that cannot easily be achieved if credit policy is kept tight to defend the exchange rate.
Jonathan Anderson from Emerging Advisors Group in Shanghai said the latest burst of stimulus - led by an 18 per cent rise in credit - is evidence that Beijing is unwilling to deflate the country's $US27 trillion loan bubble.
"The debt ratio is rocketing upwards," he said. "The authorities have clearly shown that they have no intention of addressing leverage problems. Our new base case is that the Chinese government will simply let the debt party go on until it collapses under its own weight."
The Daily Telegraph, London