The Sigificance Of China's 3 Surprises Last Week

Overshadowed by Japan's ambitious monetary policy experiment, the heightened tensions from the Korean peninsula and the nearly 1/3 increase overall cost of the Cypriot adjustment (not to mention the collapse of the Bitcon Bitcoin), China was the source of three surprises.

First, Fitch became the first major rating agency to cut China's local currency rating since the late 1990s. The A+ rating is the lowest of the major agencies and is in line with its foreign currency rating. It cited domestic debt levels and credit expansion as the impetus for its move. The outlook is stable.

One of the reasons Fitch did not cut China's foreign currency rating was due to its massive currency reserves. This is the second surprise. China reported its reserve rose by $128 bln in Q1, the most since Q2 2011 and nearly as much as 2012 as a whole (~$130 bln). The stabilization of China's reserves had been seen as a constructive development and officials heralded it as evidence that the economy was finding a new balance. The new surge in China's reserves is therefore, arguably, signaling renewed tensions.

It is tempting for some observers to see the growth of China's reserves as a sign of the hot money fleeing the QE in the US and Japan, and can cite the grind higher in the yuan, which posted new 19-year highs against the dollar today. However, the story, as usual, is more complicated and that brings us to China's third surprise this past week: an $880 mln trade deficit instead of the $1.5.4 bln surplus the Bloomberg consensus had forecast.

What was particularly striking about the Chinese trade figures was that exports to Hong Kong jumped 98%. Exports from special economic zones rose more than 300%. Exports to Taiwan rose 45, though Taiwanese figures showed a 1.2% decline in imports from China.

These largely over-looked details suggest something else may be going on. Hidden in these trade figures could be China's businesses financial machinations. Specifically, some Chinese companies may be overstating exports to repatriate more money into China bypassing the government's controls. The idea here is that the trade account may be hiding some capital account adjustments.

Hot money had been thought to have flowed out of China after Q1 12, but in the the first two months of this year, some estimates suggest the hot money returned with a vengeance--to the tune of $125 bln, which does not count the funds concealed in the trade figures. Maybe it is the low yields and deteriorating credit quality that is encouraging Chinese companies to bring funds home. Maybe expectations of yuan appreciation are behind the decision.

It most likely is not Japanese money. Japanese interest in the yuan is minimal and Japanese investors have been busy repatriating money. In fact, as we noted, last week Japanese investors sold, on a net basis, the most amount of foreign bonds in a year. Nor are Americans the featured or marginal buyer of the yuan and Chinese assets. America's current account deficit means that the US is a net importer of capital, not an exporter. Moreover, when Americans do invest overseas they typically prefer equities over fixed income and often chase returns. The Chinese stock market is a an under-performer, with the Shanghai Composite off 2,75% and compared with an almost 12% rise in the S&P 500 this year.