As we’ve tried to make abundantly clear in the wake of China’s adoption of a new currency regime in August, Beijing’s attempt to strike some kind of illusory compromise between a free floating currency and a currency that’s completely controlled by the PBoC was doomed from the word go. “Whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, [thus] the role of the market in determining the exchange rate has, if anything, been reduced in the short term,” BNP’s Mole Hau wrote last month, and as we said then, less of a role for the market means more of a role for the PBoC and that, in turn, means burning through FX reserves. 

Complicating the situation further is the fact that FX reserve drawdowns work at cross purposes with RRR cuts by sucking liquidity from the market meaning each intervention necessitates some manner of short-term liquidity injection (e.g. reverse repos, etc.) or else more RRR cuts.

Of course policy rate cuts and liquidity injections are seen by the market for what they are: attempts to ease. And unfortunately for China, that’s true whether or not the net effect of the push and pull on money markets is easing or not, and that perception on the part of the market leads to downward pressure on the yuan at which point the entire thing starts over again in a nightmarish, FX reserve-depleting circle.

Add in stepped up efforts to close the gap between the onshore and offshore spot and you have yourself a rather untenable situation and as with all things untenable, there will, sooner or later, be an endgame. 

Against this backdrop, we present Daiwa’s list of China’s three possible endgame scenarios (via Bloomberg): 

China’s balance sheet under serious contractionary pressure as money leaves and Fed decision looms, resulting in three endgame scenarios, Daiwa analysts Kevin Lai and Junjie Tang write in note dated Sept. 9.

• Scenario 1: PBOC actively intervenes by selling FX reserves to support CNY; a painful credit crunch ensues; companies come under pressure to liquidate assets to pay debts in classic case of “debt deflation”
• Scenario 2: Govt. stops FX intervention and prints massive amounts of money; interest rates and reserve ratio potentially slashed; moves put significant downward pressure on CNY and implications of a currency crisis would be global 
• Scenario 3: China muddles through between scenarios 1 and 2, where PBOC tries to manage an “orderly” downward adjustment for CNY; stimulus wouldn’t ultimately be large enough to have any meaningful impact

So the commentary on Scenario 1 there seems to suggest that ultimately, China will not be able to wholly or effectively offset the liquidity crunch caused by the FX reserve burn, triggering a contractionary nightmare. Scenario 2 looks like a rehash of Citi's recent suggestion, which for those who missed it (or for anyone in need of some Thursday comic relief), was this: 

As regards funding the fiscal stimulus, only the central government has the deep pockets to do this on any significant scale. The first-best would be for the central government to issue bonds to fund this fiscal stimulus and for the PBOC to buy them and either hold them forever or cancel them, with the PBOC monetizing these Treasury bond purchases. Such a ‘helicopter money drop’ is fiscally, financially and macro-economically prudent in current circumstances, with inflation well below target and likely to fall further.

Scenario 3 is probably what will end up playing out, but frankly, it's not entirely clear that 3 is that much different from 1, because as we noted at the outset, the market doesn't like the whole "orderly downward adjustment" idea, precisely because it telegraphs further devaluation which leads traders to speculate on more yuan weakness and that speculation necessitates more reserve liquidations. 

In short, the only "scenario" that doesn't result in an "endgame" is for everything to suddenly be fixed overnight, or, as SocGen recently put it, "for the RMB to appreciate compared to its current value will require a very positive environment for EM coupled with a cessation of capital outflows and a vibrant cyclical growth and an export recovery." That, obviously, is laughable so all we can say to the PBoC (and also to the Fed, who must consider all of the above when weighing liftoff) is "good luck."