Société Générale China economist Wei Yao thinks Chinese policymakers will take a measured approach to solving this conundrum—allowing the currency to depreciate in a controlled manner while placing more restrictions on the flow of capital out of the country.It would be better to call them half-assed capital controls. Yao goes on to note the massive hole that is "errors and omissions," which shows capital is finding ways out the country. Chinese exporters can hoard dollars in Hong Kong or other offshore banking centers. Chinese and foreigners alike can buy art, gold, property and other high value items as a way to exit the yuan, even if the asset in question never leaves the shores of China. Once expectations of depreciation set in, people will find a way out of the yuan. Finally, there's the offshore yuan which can act as a perma-drain on reserves if it consistently trades below the onshore price.
Yao notes that in this discussion, it's important to distinguish which variable is the dog and which is the tail.
"The total size of capital outflows, among other factors, is mathematically a function of the PBoC’s choice of currency policy, not the other way around," she writes. "That is, total capital outflows equal the current account surplus plus the amount of FX reserves that the PBoC is willing to sell based its target for the RMB relative to the market’s view."
The largest source of capital outflows over the fourth quarter of 2014 and first quarter of 2015 has been declines in loan and trade financing liabilities by China's corporate sector, with the majority of those flows attributable to debt deleveraging.
"Not letting the currency go requires significant FX intervention that will not prevent ongoing capital outflows but which will result in tightening domestic liquidity conditions; but letting the currency go risks more immense capital outflow pressures in the immediate short term, external debt defaults and possibly further domestic investment deceleration," says Yao.The solution to this problem is a massive one-off devaluation. China did it in the 1990s and experienced 15 years of rapid growth, plus 5 more thanks to the post-2008 stimulus.
Currency devaluation is not a solution. It is the denouement of rapid credit inflation. Given the choice between deflation and devaluation, governments will choose devaluation. Given the behavior of China's government with regards to the stock market crash, I don't think their pain tolerance is as high as people think.