How Will Shadow Funds Affect the Yuan?

Chinese markets are falling. Will the Yuan follow? Another detail in the slowing of the Chinese economy and subsequent adjustments has emerged. Bloomberg reports that shadow funds unwinds are responsible as China markets reel.

A $1.7 trillion source of inflows into Chinese markets has suddenly switched into reverse, roiling the nation’s money management industry and sending local bonds and stocks to their biggest losses of the year.

The turbulence has centered on so-called entrusted investments — funds that Chinese banks farm out to external asset managers. After years of funneling money into such investments, banks are now pulling back in response to a series of regulatory guidelines over the past three weeks that put a spotlight on the risks. Critics have blamed entrusted managers for adding leverage to China’s financial system and reducing transparency.

The Chinese stock market value fell by $325 billion in a week and bonds went up to their highest level in two years. The government wants these shadow funds under better control and supervision because they often use leveraged investment vehicles that can accelerate losses during down markets. And shadow funds have been known to invest in otherwise restricted areas of the economy, namely real estate and commodity producers who are short of cash. Pulling money out of these funds has brought the market down but did it hurt the Yuan?

Stable Yuan

Despite a stock market retreat the Yuan has remained in the 6.88 to a dollar range. In fact the Yuan remained in about this range for the five months since Trump’s election. Prior to that the Yuan had been falling in fits and starts for two years. The stabilization of the Yuan is a relief for China as it helps stem the flow of money out of China due to the plummeting Yuan.

Despite Mr. Trump’s rhetoric during the election campaign China is no longer manipulating its currency to keep it cheap. Rather the land of managed capitalism is fighting to keep the value of the Yuan from falling further. It all as to do with the state of the global economy, excessive debt in China and an economic plan that no longer works like it did as China was in the first part of its growth cycle. Bloomberg says that Yuan pessimists are multiplying.

The well-to-do have been moving their assets into dollars for a few years as they see the greenback as a safe haven while the Yuan falls in value.

And the flight of capital from China reduced China’s currency reserves.

As China’s economic miracle unfolded the nation accumulated impressive foreign currency reserves. In 2015 Chinese reserves reached $4 Trillion and since then have been falling as China has sought to support a falling Yuan. According to Trading Economics reserves are down to $3.16 Trillion as of September of 2016. Bloomberg reports that Chinese reserves fell $80 Billion more in October. They suggest that China could be due for a shock fall in foreign exchange reserves.

It is likely that people who were unable to move money offshore have used shadow funds to gain more profit to make up for a falling Yuan. That loophole is being closed. But a stable Yuan may reduce the inclination to move money offshore or take on undue risk in search of profits.