Usually, housing bubble bursts are followed by defaults and financial crises. Foreign capital is fleeing China, and the country’s national currency is on the verge of catastrophic collapse. Economic and monetary data point to a financial crisis in China right before the 20th Party Congress.

Chinese currency in danger of collapsing

A significant reason for the yuan’s decline stems from the CCP’s “Zero-Covid” policy in the face of the COVID pandemic throughout China. That not only slows down production for exports but also affects domestic demand and consumption. As a result, consumer productivity and producer productivity in China fell below expectations in July. With millions of workers laid off during these seemingly endless lockdowns, the incomes of Chinese consumers have plummeted; while their psyche declines.

Falling export earnings, slowing production, and shrinking consumer demand are not the only negative consequences. Another factor is the collapse of the property sector, which accounts for about 29% of China’s GDP. This collapse has a substantial negative impact on the psychology and attitude of consumers. That’s especially so, as investing in real estate development is a significant part of individual retirement portfolios across China.

A study by the Peterson Institute for International Economics (PIIE) said: “Nearly 60% of the total assets owned by urban Chinese households is property. That share is even higher for lower-income households. As a result, a sharp property price decline could trigger social unrest, something the Chinese government would want to avoid at all costs.”

The reaction of Chinese property investors has been unprecedented. Millions of owners have stopped or are threatening to stop making mortgage payments on unfinished or deeply devalued real estate projects. This boycott could affect 200 projects in 80 cities and have severe consequences for the financial sector.

While incomes are falling, inflation is rising. In short, Chinese consumers face a double-edged sword: lower incomes and higher prices. As a result, millions of property investors are angry, and the potential consequence is increased domestic unrest.

The consequences don’t stop at China’s borders. Beijing’s continued devaluation of the yuan, coupled with a real estate crisis and slowing growth, is driving foreign investment away from China.

Capital fleeing China at a record rate: Legal and illegal

On Sept. 6, Japanese media outlet Japan Forward published an analytical article pointing out that the direct cause of the yuan’s continued weakness against the USD was that foreign investors sold Chinese bonds. The current capital flight could lead to a financial crisis as bad as that of Thailand in 1997.

Since February 2022, China’s bond prices and the yuan’s value have fallen in tandem. As a result, in June 2022, foreign holdings of Chinese bonds decreased by about $120 billion compared to January 2022.

For decades, China has maintained its government bond yield spread at a much higher level than that of U.S. Treasury yields. So China attracted a large amount of foreign capital into the country’s long-term capital market. However, the Fed overreacted monetary policy, causing this trend to reverse. As a result, an unprecedented phenomenon has occurred, the 10-year Chinese government bond yields have been lower than the U.S. government bond yields. Moreover, the gap has widened in recent months.

The widening interest rate differential between China and the U.S. has increased the risk of investing in securities in China, including bonds and stocks, causing foreign capital inflows to decrease. This difference alone can make the yuan weaker. In addition, since for securities denominated in yuan, their USD value will decrease when the yuan depreciates, and foreign investors will lose interest.

According to Washington-based Institute of International Finance (IIF) data, foreign capital has withdrawn from China since foreign investors sold off $30.7 billion in Chinese bonds in March. As of July, the total amount of capital flight is 83.6 billion USD. IIF once commented that capital outflows from China (not only from the sell-off of government bonds) were at a record level.

Singapore’s Lianhe Zaobao reports that Henley & Partners, London-based immigration and investment consulting firm, points out that an estimated 10,000 wealthy people in China are looking for opportunities to emigrate to other countries. On average, each person will bring about $4.8 million, resulting in equivalent asset flows from China.

Of these 10,000 individuals, about 4,200 have emigrated abroad between January and June of this year. According to the selection of those who have migrated, their preferred country is the United States, followed by Canada, Australia, the United Kingdom, and Singapore.

Vicious circle: Devaluation of yuan leads to capital flight

The Central Bank of China (PBOC) will issue more yuan based on the size of the increase in foreign exchange reserves, but foreign exchange reserves continue to decline sharply.

Likewise, increased foreign investment in Chinese stocks and a more significant foreign trade surplus are necessary conditions for raising foreign exchange reserves. However, foreign investment in China continued to decline. China’s exports are not likely to increase due to the downturn in the U.S. economy and other markets. The only option is to devalue the yuan to boost China’s manufacturing and export advantages. However, this will push capital outflow faster.

Articles in the Japanese media pointed out that the yuan’s devaluation in 2015 led to capital flight. This time, China could fall into the double disaster of a financial crisis and economic turmoil.

On Sept. 8, Federal Reserve Chairman Jerome Powell delivered a hawkish message that all monetary policy tools will be used to curb inflation in the U.S. As a result, the interest rate increase for the third consecutive month should be 0.75%.

Observers said this is bad news for China, as it narrows the PBOC’s rate cut space, especially when China needs to cut interest rates most. Instead, China’s central bank needs to tighten capital controls to prevent further capital flight.

On Sept. 5, the PBOC decided to lower the foreign exchange deposit reserve ratio of financial institutions from 8% to 6% from Sept. 15. The market generally thinks that when the yuan/USD exchange rate reaches the critical milestone—level 7, the regime will need to intervene in the exchange rate.

The market generally thinks that the above move of the PBOC is sending a signal to limit the rapid devaluation of the CNY. Lowering the foreign exchange reserve ratio means that the foreign exchange deposits that the underlying banks transfer to the central bank will decrease. As a result, the Foreign exchange that the underlying banks can use will increase, and the foreign exchange quota available for lending will be expanded. As a result, the supply of foreign currency in the market will increase, thus promoting a decrease in the foreign exchange rate. As a result, the corresponding CNY exchange rate will increase. Therefore, reducing the foreign exchange deposit reserve is a measure to prevent the yuan’s devaluation.

Avoiding the yuan’s rapid depreciation may be Beijing’s best hope. However, at some point, instead of trying to maintain a fixed rate, the CCP may float the CNY. However, doing so would cause the CCP to lose control of the CNY. Some argue that’s unlikely, as the CCP wants complete control over the Chinese economy, including the country’s currency.

Other analysts argue that the causes of the yuan’s depreciation are not policy-driven but structural. In that case, Beijing may have to float the yuan because it cannot control the flow of capital from global investors. In addition, the yuan’s growth depends on ineffective but politically loyal state-owned enterprises.

Simon White of Bloomberg agrees: “The forces causing the yuan to decline are structural, and there is a mounting likelihood that China may eventually drop the fixed-exchange rate regime altogether.”

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