Recent trends in the RMB

This year the RMB has bucked its recent trend and remained broadly stable against the US dollar for the first half of 2017. As the Trump reflation trade has unwound to some degree, and the dollar retraced, the RMB has seen some depreciation against its main trade partners. For policymakers in China this is a convenient outcome, though there exists a delicate balance to maintain. Too fast a depreciation risks discrediting recent emphasis on ‘relative stability’ and the recent change to the PBoC’s fixing mechanism looks to be a reflection of this need.

Key RMB movements so far in 2017

Up until the end of May, the CNY traded in a narrow range against the US dollar, though at the beginning of March a gap opened up between the trade-weighted US dollar and the direct bilateral USDCNY exchange rate (figure 1). While sentiment on China this year has improved on a relative basis, market participants still worry about a number of issues including softer growth, financial instability, and the impact of deleveraging, which has encouraged this disconnect. A flat USDCNY exchange rate in the face of a depreciating dollar more generally, has therefore led to a decline in the trade-weighted RMB index (figure 2).

A healthy easing

To policymakers, this is not a bad outcome. Firstly, a trade-weighted depreciation provides some much needed offsetting stimulus to counterbalance rising lending rates and efforts by officials to crack down on leverage in the economy, which will weigh on growth (figure 3). Secondly, China has battled both speculative and domestic outflows, and depleted around a quarter of its reserves in the process. A weak dollar but stable China/US bilateral exchange rate allows for a supportive depreciation, while helping to discourage capital outflows and replenish currency reserves (figure 4). Admittedly, it is difficult to tell whether the recent stabilisation in capital outflows is indeed down to improved domestic sentiment or more effective capital control measures.

The new fixing mechanism for CNY

While a trade-weighted depreciation is certainly convenient, PBoC officials will be keen to maintain perceptions of ‘relative stability’, whether that be against a currency basket, or against the US dollar (the emphasis appears to change depending on the dollar’s trend). In line with this objective, towards the end of May, the PBoC unexpectedly changed its USDCNY fixing mechanism, adding a counter-cyclical adjustment factor. Previously, the fix was determined by two components primarily; the prior day’s close in USDCNY and an adjustment factor which aims to keep the trade-weighted RMB stable.

The first component helps to explain why USDCNY and the DXY index recently diverged, and the new countercyclical adjustment factor aims to promote two-way flexibility but prevent these kinds of unwarranted divergences in the future. In the days running up to the fixing change, USDCNY fixings came in far below what previous market closes implied, and the recent change could partly be an ex-post rationalisation of these lower fixes. In effect, this new methodology gives the PBoC a greater degree of discretion over the fixing rate, should it judge USDCNY to be diverging from fundamentals.

Total returns tell an alternative story

The recent depreciation of the RMB index has been part of a longer-term adjustment to macro adjustment under which the RMB has depreciated on a trade-weighted basis by around 8.5% since the start of 2016. However, from the perspective of exposure to Chinese currency risk, it is essential to assess returns on a total returns basis which include the accrual interest rate differentials, rather than the spot performance independently.

While the CNY has depreciated by 4.7% and 5.0% against the US dollar and G4 currencies respectively since the start of January 2016, total returns for the same period were positive at around 1.4% and 2.3%, respectively. The RMB has therefore compensated holders on a total return basis via a higher nominal interest rate. According to prevailing forward currency curves, this interest rate differential is expected to persist into the future and if so, will continue to form an important component of return for the RMB.

Chinese currency decoupling


• Does the recent weakness and volatility in the CNH spot and short-tenor forward market herald a new era of Chinese capital outflows?


Markets in the new year have not only been greeted by a sell-off which reminds us that 2015 is not still quite over, but also by the twin fears of a continued US Fed policy normalisation coupled with the possibility of a harder than expected landing in China. What the oil price and equity price action may be telling us is that new sources of growth will be hard to find over the medium term. If that old, steadfast friend, namely, the US consumer is no longer the main global growth locomotive, who takes over the baton?

What this points to is the ever more important question : will that new global growth be coming from China 10 years from now as it rebalances its economy to a domestic demand led one, in which case we should come to see recent weak economic activity indicators in China as mainly cyclical, or does the data suggest that this is a deeper, more intractable issue? The latter is typically known as the middle-income trap, which is where so many EM countries have fallen short in the past. In essence, economically and institutionally, how do you transition from being a relatively low cost manufacturer to higher value added offering to the rest of the world, primarily around services? In particular, how does one transition from a “one-sided” (i.e. both current and capital account in the black) to a more balanced external account, with inevitable capital outflows and currency dislocations along the way?

The initial battle ground for this transition nearly always takes place in the currency markets and in January alone we have witnessed at various points a notable de-coupling of CNH and CNY spot rates, with the short-term CNH forwards (up to a week) reacting violently to alleged PBoC intervention to bring them back into line with onshore counterparts. The spread between the two (CNY and CNH spot) is, at the time of writing, within the historical norms, but at what cost to Chinese official reserves over the course of 2016 should this incipient volatility continue ?

Generally, I believe that what we are seeing is the start of generalised outflow pressure from China expressing itself via speculative shorts in CNH which the People’s Bank of China (PBoC) is not happy about. If this were merely a problem of the unwinding of historic the RMB carry trades, and the concomitant paying down of USD liabilities, it wouldn’t be a terribly big issue for the PBoC, merely a headache, as many before. But, what if this is a classical current account liberalisation issue, with persistent outflows to come over the coming years, if not decade? The data is not conclusive yet, but this is certainly to prove one the most important issues in 2016. Just as the build-up of Chinese FX reserves over the past 15 years led to a mutually beneficial cocktail of lower yields in the US as well as credit expansion in China, the reversal of this process no doubt leads to deflationary pressures across the world and credit contraction. This has implications for global asset prices, and also for global inflation, which may stay lower-for-longer as global real yields edge higher.

China: macro myth-busting

  • In this blog post we offer our thoughts on three strategically important questions regarding China’s macroeconomic and FX policy, for which there appears to be little consensus.
  • A disaggregation of the decline in foreign exchange reserves and the balance of payments reveal some less sinister causes of reserve drawdowns and capital outflows.
  • Looking at the bigger picture, we believe China is stuck in an uncomfortable position within the “impossible trinity” and see further exchange rate and capital account liberalisation key factors in finding a new equilibrium.

1. Should we worry about Chinese reserves?

Last week the People’s Bank of China (PBOC) released the latest foreign exchange reserve numbers for November which showed a sizable drop in reserves of $87bn to $3.44tn. With heightened uncertainty surrounding China’s macroeconomic outlook and stability, this number has received a lot of attention because many use it as a proxy for the PBoC’s activity in the foreign exchange market. Whilst this is broadly true, the numbers require some careful interpretation and adjustments to truly understand the size of PBoC interventions.

Firstly, an exchange rate adjustment is required; it is understood that around 30% of Chinese reserve assets are denominated in Euros, which when converted to dollars for reporting purposes can create large valuation changes. We estimate that since the beginning of the decline in reserves in Jun-14, around 50% of the total $555bn drawdown can be attributed to the decline of the euro, with around $45bn of November’s $87bn drop from the same source. Secondly, the PBoC has committed to other expenditures totaling roughly $195bn which require the use of reserves, including the establishment of the New Silk Road Fund, related re-capitalisation of the China Export-Import bank and the New Development Bank, and Asian Infrastructure Investment Bank capital base contributions.

We cannot be certain how much has been disbursed to date but if we assume around $100bn has been disbursed (which covers distributions related to Silk Road agreed in April, and bank capitalisations), this would account for almost 20% of the decline in reserves. Combining this with valuation effects, that brings us to a final residual reserve drawdown, attributable to PBoC interventions/capital outflow coverage of around -$165bn. While this number is still large, our intention here is to demonstrate that a large part of the headline number can be rationally explained by factors other than the PBoC throwing the kitchen sink at the currency.

Reserve attribution

2. How much capital flight has there been?

To figure out how much capital flight there has been, we do a little balance of payment accounting. Unfortunately the BoP data only runs to 3Q15 but we can work with what we have. Firstly, we adjust changes in reserves for the factors we talked about above in order to approximate changes reserves related to PBoC intervention, then we approximate capital flows from China by solving the balance of payments equation for capital outflows excluding foreign direct investment: Other Capital Outflows =  -(Current Account + Adjusted Reserves + FDI). By this measure we estimate that from 3Q2014 to Nov-15 we have seen cumulative capital outflows of around $560bn, or $33bn a month.

Not all of this is ‘capital flight’. Firstly Chinese corporates have been covering their dollar liabilities which originate from when the Renminbi was a “one way upward bet” and yields in China were far more attractive relative to the US. Investment position data suggest this could have accounted for about $270bn of outflows from 3Q14 though 2Q15, so make up about 50% of the total ‘outflows’ (or more if corporates increased USD exposure in 3Q). The remaining outflows of roughly $280bn are more representative of sentiment driven flows, part of which are FX deposit outflows, thought to be in the order of $100bn according to a research report by J.P. Morgan.

We think other less transparent and more informal channels make up the remaining $182bn gap (which is calculated as a residual balancing item).  Again, many of the deposit outflows are likely related to the prospect of higher US rates and a stronger dollar, while some will undoubtedly reflect worries of a hard landing or imposition of capital controls. In essence, these ballpark numbers serve to demonstrate that the magnitude of “panic” outflows appear smaller than what traditional gauges would suggest.

Capital flows


3. What is the PBoC game plan?

As well as slowing economic growth, China is in the midst of a dis-inflationary episode and must of course attempt to correct this. Unfortunately for the PBoC, it cannot drop interest rates in the same fashion as the ECB or the SNB. In order to do so, the PBoC must manoeuvre away from its current position within the “impossibly trinity” – the observation that a central bank can only achieve two out of three of the following policy options: independent monetary policy, a fixed currency, and open capital account. Currently the lines are blurred with a partially open capital account, a managed floating exchange rate, and restricted monetary policy independence. At present, cutting rates to historic lows risks a fresh round of capital flight, with the PBoC then having to sell an uncomfortable portion of its currency war chest, thereby tying up domestic liquidity and counteracting lower borrowing rates.

To overcome this policy contradiction the PBoC must (and is) move towards a free floating exchange rate. In August, PBoC Deputy Governor Yi Gang clearly expressed intention to move towards a clean float, and the recent publication of the RMB trade-weighted exchange rate confirms that exchange rate liberalisation is not losing steam. This is undoubtedly the most sensible policy option for the PBoC at this juncture. If the transition is successful, the PBoC gains unconditional control of monetary policy, the currency helps absorb adjustments emanating from the increasingly open capital account, and the market engineers a weaker exchange rate. In the short term this is convenient for China in the context of slowing growth, low inflation, other regional currency depreciation, and U.S. opposition to state manufactured currency weakness. While this adjustment takes place we may expect reserves to decline further towards $3tn, but if all goes to plan, we should see the pace slow as the renminbi takes over the equilibrating role.