Understanding China’s New Currency Policy


February 08, 2016

This year, concerns about China – ranging from growth prospects, to policy missteps, to currency depreciation, to bad communications – have rattled markets. Many investors continue to worry that China will both want and have to allow the Chinese Yuan (CNY) to depreciate significantly because in their minds: 1) growth is falling off of a cliff; 2) the exchange rate is the only effective policy tool left to counteract this decline; and 3) China will lose control of its currency as capital outflows drain its foreign exchange reserves. In addition, since China is the largest trading partner of many countries, particularly in Asia, many investors fear a large depreciation will spark a global currency war (and could even break Hong Kong’s 32-year peg).

While China faces many challenges, including excess capacity and inventories in manufacturing and property, and rising corporate leverage, we do not expect them to implement a ‘mega-depreciation’, which we define as a quick move lower of at least 15%. We see the risks of such a depreciation outweighing the benefits. And there are better ways to support growth. In addition, we see China’s shift to a more flexible exchange rate, starting by managing the CNY against a trade-weighted basket – rather than the US dollar – as beneficial.

In the near-term, uncertainty over the direction of China’s economy and exchange rate will likely continue to weigh on markets and lead to periodic bouts of volatility. In addition, there remains a risk that policy missteps, poor communications, and/or an excessively heavy handed enforcement of capital controls could further undermine investor confidence. However, we believe that as investors become comfortable with China’s basket based exchange rate policy and the greater USD/CNY volatility that comes with it, their fears of a large depreciation should subside. We expect the CNY to be modestly weaker against the trade weighted basket, and end the year around 6.9/USD. We expect that China will continue to tighten controls on outflows to slow the drain on foreign exchange reserves until market expectations on the CNY are more firmly anchored.

Below, we go into further detail of why we don’t believe China will pursue a mega-depreciation, along with our outlook on the currency, capital controls and the economy.

As we stated in our white paper last summer (Anchors Away? Assessing Changes to China’s Exchange Rate Policy - August 24, 2015), we believe the changes last August to China’s exchange rate policy were driven in part to address concerns raised by the IMF in China’s now successful campaign to join the SDR basket. The CNY’s depreciation from November 2015 until early this year was, in our view, largely driven by China’s desire to avoid a further strengthening of the CNY against a basket of currencies of its major trading partners (the “trade-weighted basket”), which by late October was close to the August highs and up 15% since mid-2014. However, many investors interpreted the moves as indications that Chinese authorities wanted to depreciate the CNY significantly against the US dollar. The lack of clear official forward guidance only served to heighten market uncertainty.

CNY depreciated against the USD when the basket hit highs & markets expected further USD strength vs. major currencies.

Source: JP Morgan, Standard Chartered Bank; Data as of February 5, 2016

China’s growth is slowing, but a weaker currency won’t fix what ails the Chinese economy.

Investors should ignore recent headlines that “China’s growth has fallen to the lowest level in 25 years” and “Chinese growth disappoints at 6.8% vs expectations of 6.9%.” Data prints over the last several months – while weak – have not been significantly worse than expected and haven’t changed our economic outlook for growth of around 6-6.5% this year (slightly below consensus). More importantly, as we’ve noted in the past, investors should pay more attention to how China is growing, rather than how fast. It’s no surprise that growth is slowing as long-term tailwinds, like demographics, turn into headwinds, recovery in global demand continues to disappoint, and the “old” Chinese economy (heavy manufacturing and property) cuts back investment in the face of too much productive capacity, inventories and debt. At the same time, parts of the “new” Chinese economy (service sectors like leisure, health care, education, e-commerce, and clean tech) are growing at double digit rates. And even with China growing at only 6%, it’s estimated the economy will expand this year more than the U.S., Germany, and France combined (in US dollars).

A Tale of Two Economies: Sharp Downturn in Manufacturing & Construction, Services Steady

Source: National Bureau of Statistics of China; Data as of December 31, 2015

Investors should also be cautious about viewing a plummeting stock market as a bellwether for the broader economy. Chinese equity markets have traditionally been volatile and represent a small share of corporate financing and household wealth. A plunging stock market also doesn’t imply that China is experiencing a financial crisis. While many Chinese corporations have too much debt and banks’ non-performing loans are rising, money market rates have remained low and stable, compared to the spikes seen in the U.S. during the global financial crisis and in China during 2013. One reason why Chinese depositors and lenders are willing to provide financing at low spreads is the fact that a large share of China’s debt is concentrated in local governments, state-owned enterprises, and state-owned banks backed by an AA-rated sovereign. However, this confidence comes with long-term costs. China needs to scale back government guarantees and allow more defaults so credit risk can be better priced and more resources can flow to China’s most dynamic firms. There remains a risk that the necessary defaults of corporate debtors could rattle credit markets.

We don’t believe the depreciation of the CNY is meant as a beggar-thy-neighbor policy to grab growth at the expense of the rest of the world. First, China doesn’t need a weaker currency to stay competitive. While it’s true that exports have been declining (down 5% y-o-y in 2015 Q4), and some firms and sectors have been hit hard, China’s exports have fallen less than exports from most other Asian economies (for example in Q4 Korea’s exports were down 12% y-o-y and Taiwan’s were down 14%). As a result, China has been gaining global market share even as the Yuan has appreciated 30% against the trade-weighted basket over the last 5 years. The main drag on China’s exports has been weak global demand, not a strong currency. Moreover, China has been getting more bang out of each export buck because the share of Chinese exports actually made, rather than just assembled, keeps rising as they move up the value added chain and component manufacturers move onshore. Finally, as China gains market share, maintains one of the highest growth rates among major economies, and sees its current account surplus climb again towards 2.5% of GDP, it would be hard for this year’s G-20 chair (China) to justify a mega-depreciation to its G-20 partners.

The main drag on Chinese exports has been weak global demand, not a strong currency. China continues to gain market share.

Source: National Bureau of Statistics of China, IMF; Data as of December 31, 2015

In addition, Chinese policy makers are well aware that currencies of many of their trading partners (particularly in Asia) will track any CNY weakness, limiting China’s ability to gain any competitive advantage. For example, since August on a trade-weighted basis the depreciation of the CNY has been only about two-thirds of its 5.5% depreciation against the US dollar. Finally, since it would be difficult to convince markets that it would be a one-time event, a mega-depreciation risks destabilizing financial markets, raising risk premia, outweighing any modest trade benefit.

With China choking over too much capacity and debt, we agree that trying to boost growth by easing monetary policy would be neither effective nor desirable. But that doesn’t leave China dependent solely on a weak currency. Support for growth is rightly shifting to fiscal policy with government spending picking up, increased tax incentives in autos and other goods to promote consumption, and the refinancing of local government debt is freeing up funds for infrastructure. We expect further fiscal stimulus will be announced when the 2016 budget is released in March.

Source: Bloomberg; Data as of December 31, 2015

While capital outflows and the decline in foreign exchange reserves have been large, and may continue near-term, some flows are likely to dissipate.

China’s headline foreign exchange reserves have fallen $760 billion from their June 2014 peak. Roughly one-third of this reflects the decline in US dollar value of non-dollar reserves. Nevertheless, the central bank has been selling a lot of dollars. With a rising trade surplus (over $175 billion in 2015 Q4) and China still likely receiving more direct investment inflows than outflows, this means outflows were large (such as Chinese tourist spending and bank lending abroad, as well as portfolio outflows). A rough estimate of all these other net outflows is $350 billion for 2015 Q4. The main drivers of outflows have been:

  1. Rising outward direct invest as Chinese companies want to be closer to their foreign customers;
  2. Rising overseas lending by Chinese banks as they follow their corporate customers abroad;
  3. Diversification of wealth as Chinese investors reduce their large underweight allocation to foreign investment (though this has been offset by inflows as foreigners reduce their large underweight allocation to Chinese investment);
  4. An unwind of the carry trade as Chinese corporates refinance foreign currency denominated loans and bonds with lower cost CNY loans and bonds, which reduces currency mismatches;
  5. A reversal of foreign equity flows in response to the Chinese stock market sell-off; and
  6. Other capital flight, including Chinese investors moving assets overseas to keep them out of the clutches of anti-corruption investigators.

The first three factors are trends that have been going on for years and are expected to continue as China develops. However, large outflows linked to the carry trade and China’s stock market bubble are likely to dissipate over time. Most importantly, we see little evidence of large scale currency substitution, which occurs when people lose confidence in their currency and shift their savings to foreign currency or hard assets like gold. This tends to happen in countries that are experiencing high inflation. China has very low inflation, and in some sectors, deflation. Finally, a trade surplus of $500-600 billion this year will help counter the impact of these outflows on the CNY.

Trade balance improving slightly, FDI is flat and there are initial signs that the outflows from carry trade unwind may be slowing.

Source: National Bureau of Statistics of China, China Ministry of Commerce, Bloomberg; Data as of December 31, 2015

The carry trade is being unwound as Chinese borrowers repay foreign currency denominated debt to foreigners...

Source: National Bureau of Statistics of China, China Ministry of Commerce, Bloomberg; Data as of December 31, 2015

...and domestic banks.

Source: National Bureau of Statistics of China; Data as of December 31, 2015

China retains tools to keep an exchange rate depreciation orderly.

China’s central bank still has over $3.3 trillion in foreign exchange reserves. Using the IMF’s most up to date methodology, which looks at a range of potential drains on foreign currency, we estimate that China still has 1.5 to 2 times the minimum recommended reserves. And as debt and other external liabilities get repaid and exports fall, the need to hold foreign exchange as a buffer also declines. So while China reserves are more than adequate to cover another $400 billion drop over six months, large declines in foreign exchange reserves risk undermining confidence. As a result, Chinese authorities have turned to other tools to stabilize the currency, such as 1) boosting the cost of shorting the currency (particularly in Hong Kong), 2) limiting Chinese households’ ability to invest abroad, 3) limiting banks’ ability to engage in certain types of cross border and offshore Yuan lending, and 4) stepping up enforcement of existing capital controls.

Foreign Exchange Reserves Have Fallen But Are Still Large

Source: People’s Bank of China; Data as of December 31, 2015

While market communications have improved, uncertainty will continue to weigh on markets.

Shifting to a new policy framework is always fraught with uncertainty and risks. That’s why market communications are so important. The heavy handed policy response to stock market volatility, poor market communications, and the lack of transparency (in data and policy making) has undermined investors’ confidence in the willingness and ability of Chinese institutions and policy makers to carry out reforms. Fortunately, there have been some recent improvements in market communications, at least for the exchange rate. In mid-December, the China Foreign Exchange Trading System (CFETS), an affiliate of the central bank, released a trade weighted basket and comments by officials since then have stressed that, having brought the basket down from its August 2015 peak, they see no need for a further large depreciation against the basket.

Though it could have been better communicated, a more flexible currency is the right move.

While China doesn’t have a trade competitiveness problem, it has a deflation problem in manufacturing (but not services). Chinese leaders have made clear that the priorities for 2016 are reducing excess manufacturing capacity, unsold property inventories, and leverage. While we welcome this (and wish they would go faster), this is likely to add to deflationary pressures.

Source: National Bureau of Statistics of China; Data as of December 31, 2015

Given this, it makes sense for China’s central bank to give itself more room to combat deflationary pressures by loosening the CNY’s tie to the US dollar and targeting a broader range of currencies. In this light, it’s not surprising that China let the CNY weaken against the US dollar when the CNY against the trade-weighted basket had strengthened and markets were expecting even further US dollar appreciation.

In addition, China has scaled back controls on capital flows over the last year in its successful bid to join the IMF’s SDR basket. The more it opens the capital account, the more it runs into what economists call the “impossible trinity” of an open capital account, an independent monetary policy, and a rigid exchange rate. Given that China will always insist on an independent monetary policy, it needs to give the CNY more room to move, and/or re-impose some capital controls. We expect China to do both. With the re-imposition of controls, China’s long-term goal of promoting international use of the Yuan will take a back seat.

The Outlook for the Yuan in 2016
China has given us hints about what it considers an excessively strong basket, and the basket has stayed in a band of +/- 2.5% for the past year. However, despite statements that there’s no need for a significant depreciation of the basket, there is uncertainty over how low the floor is. Ultimately, China can’t adhere to too rigid a basket, or it would be just swapping one kind of exchange rate peg for another, limiting the central bank’s ability to set interest rates, as is the case for Singapore. A basket may ultimately be a transitory tool for anchoring expectations as China moves to a more flexible regime. Still, managing the exchange rate against a basket will likely lead to more volatility in the USD/CNY rate.

With some modest additional US dollar appreciation against other major currencies, CNY depreciation against the US dollar in the mid-single digits (to around 6.9 by year-end) would allow the basket to weaken modestly and keep the rate of depreciation within current forward implied yields (limiting its attractiveness as a speculative short). A weaker Yuan will likely weigh on currencies of other Asian economies, particularly those that sell components whose production is moving to the Mainland and those that compete
with China in other export markets, such as Korea, Taiwan, Singapore, and Malaysia.

As mentioned, in the near-term, uncertainty over the direction of China’s economy and exchange rate will likely continue to weigh on markets and lead to periodic bouts of volatility. In addition, there remains a risk that poor communications, and policy missteps such as heavy handed enforcement of capital controls in a manner similar to what we saw last year in the stock market, could further undermine investor confidence. However, we believe that as investors become comfortable with China’s basket based exchange rate policy and the greater USD/CNY volatility that comes with it, their fears of a large depreciation should subside. And this eventually should be supportive for risk sentiment and risk assets.

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