Uncertainty over China’s exchange rate regime has accentuated local and global risks. Within China, fears of currency volatility and depreciation have reinforced capital outflows and asset price weakness. Globally, fears of ‘hard landing’ and financial pressure in China have reignited deflation concerns. Public information does not indicate a sharp slowdown or financial distress, but commentators distrust official data of an economy with great systemic vulnerability.

The below are excerpts from various sources listed at the end of the post.

Headings, cursive text and references to other posts have been added.

Capital outflows and external balances

“China’s FX reserves have been falling since June 2014 [reaching USD3.65 trillion in July 2016, from USD3.99 trillion a year earlier]…A big increase in capital outflows from China has been principally motivated by the end of the RMB’s ‘one-way-bet’, a period of persistent currency appreciation and low FX volatility that lasted between 2010 and early last year…Expectations of further currency depreciation – particularly in the wake of [the August 11] move by the PBOC to make the exchange rate more ‘market-determined’ – will also help to fuel capital outflows from China.”
[Citibank EM Economics team, Aug 21 2015]

“China’s corporate sector borrowed USD heavily before early 2014, bringing USD onshore to profit from higher CNY yields and CNY appreciation…[Since then] corporate overseas FX debt repayment [turned into] a driver of capital account outflows. China’s financial account outflows continue to be driven by a significant drop in loans… We estimate that non-FDI capital outflows averaged USD 50bn per month in the past 12 months…[and] to have covered China corporates’ aggregate short USD position… This suggests that outflow pressures via the financial account may slow. However, given the uncertainty over China’s latest CNY move, companies may hedge their short USD positions or build more USD assets.“
[Standard Chartered, Aug 14, 2015]

Over the past years gradual liberalization and reform of monetary policy have created greater scope of international capital flows and related risk of short-term market dislocations (view post here).

“According to the latest data from SAFE [State Administration of Foreign Exchange] total external debt is about USD1.67 trillion. Excluding SDRs owned by the PBoC and offshore RMB debt, the total amount of FX debt is around USD833bn, with a significant portion likely being short-term in nature and not actively hedged. Our understanding is that the hedging ratio is below 20%.”
[Deutsche Bank, Aug 21, 2015]

“The renminbi has appreciated considerably in real effective exchange rate terms, up 55% since the exchange rate reform in 2005… Despite this appreciation, 2015Q1 registered a strong trade surplus, driven largely by lower commodity prices and the domestic slowdown.”
[IMF, Aug 14, 2015]

“China’s external balances do not suggest the need to depreciate: China still runs current account surpluses – about 3% this year, which may seem low compared with the surpluses of the past, but is still high when considering a ‘normative’ model as employed by the IMF. China’s international investment position (IIF) is largely positive, mainly due to its nearly USD4trn of official reserves… Lower commodity prices imply a positive terms-of-trade shock for China, which should not only boost the current account surplus but also implies a more appreciated equilibrium real effective exchange rate.”
[Barclays, Aug 14, 2015]

See IMF charts on external liabilities at the end of the post.

FX policy change

“In order to enhance the degree in which the USDCNY reference rate reflects the benchmark and also market, the People’s Bank of China has decided to improve the USDCNY daily fixing mechanism. From August 11th, 2015, ahead of the market open, market makers should refer to the previous trading day FX closing price, taking into account FX supply and demand and also international FX price changes to submit their central parity estimates…The market still needs some time to adapt. The PBC will monitor the market condition closely, stabilizing the market expectation and ensuring the improvement of the formation mechanism of the RMB central parity in an orderly manner…the PBC will enhance the flexibility of RMB exchange rate in both directions and keep the exchange rate basically stable at an adaptive and equilibrium level,”
[People’s Bank of China, Aug 11, 2015]

“The reform to the fixing mechanism was made to make it more market oriented….The People’s Bank of China (PBoC) sees a market-oriented FX rate as more beneficial for long-term market stability, as it acts as a stabiliser for economic development and the balance of payments. It is also beneficial for CNY internationalisation. A pegged exchange rate, on the other hand, may appear to be stable, but in reality creates instability…The stable USD-CNY …led to a large rise in the CNY trade weighted exchange rate index..”
[Standard Chartered, Aug 14, 2015]

“There are essentially two different ways to explain the move by the PBOC to make the CNY exchange rate more ‘market-determined’.

  • One focuses on the idea that the exchange rate has been added to China’s stimulus tool-kit…a round of fire in a global currency war.
  • An alternative explanation…relates…to the IMF’s decision…about whether or not to include the RMB in the basket that underpins the…Special Drawing Right (SDR), the international reserve asset created by the IMF…

The IMF identifies two main criteria that will be used to assess the RMB’s eligibility for inclusion in the SDR basket: i) a country’s share in global exports; and ii) the requirement that a currency be ‘freely usable’. The key thing here is that ‘freely usable’ is not the same as ‘freely convertible’. So we may soon be in a world where the RMB becomes a reserve asset – which would happen by definition if it becomes part of the SDR – without being freely convertible. In other words, the concept of a reserve asset will no longer be ‘one size fits all’: some reserve currencies can be fully convertible, and others not…The loss of FX reserves [in 2014/2015] might exacerbate a deterioration in monetary conditions, and therefore threaten growth…The biggest pay-off of getting the RMB into the SDR basket will be to catalyse gross capital inflows, and therefore help to ‘finance’ the gross capital outflows that China is likely to see.”
[Citibank EM Economics team, Aug 21 2015]

“In reality, China’s devaluation was puny [over the two weeks that followed the regime change], less than 5% in all. Compare that to the euro’s 20% drop so far this year, or the yen’s 35% dive since Japan embarked on its “Abenomics” reform program in late 2012, and it is clear that overblown headlines about the renminbi’s ‘plunge’ were woefully misleading. Had China really wanted to grab a bigger share of world exports, it is hard to imagine that its policymakers would have settled for such a modest adjustment.”
[Cohen, Aug 19, 2015]

Economic slowdown

“China has enjoyed several decades of strong economic development, punctuated by particularly rapid growth in the years before the global financial crisis (GFC): real GDP growth in China averaged around 11% (yoy) from 2000-2007… While growth was hit during the GFC, it rebounded sharply again in 2010, reaching 10.6% according to official statistics. After the peak in 2010, however, Chinese GDP growth has slowed down significantly. In Q1 this year, official GDP recorded 7% growth, the lowest since the GFC. Policy makers have publicly acknowledged this trend…as one of the key characteristics in the ‘new normal’ of China’s economic development.”
[Goldman Sachs, Jun 22, 2015]

“Growth is projected at 6.8 percent this year, down from 7.4% last year. This slowdown, which is in line with the authorities’ target of around 7% and [IMF] staff’s recommended range of 6.5 to 7%, reflects progress in addressing vulnerabilities, including slower total social financing (TSF) growth, tighter oversight of shadow banking, a correction in real estate, and a new budget law.”
[IMF, Aug, 2015]

“The uncertainty around official China economic data is particularly large, which has fuelled suspicions that the authorities may know more about the true state of the economy than can be found in official statistics. This may explain the strong reaction in global markets to the PBoC’s announcement of the FX regime change: coming soon after the release of weaker-than-expected activity data for July, markets likely interpreted the sudden devaluation of the currency as the authorities’ implicit acknowledgement that growth is much weaker than expected and that the other policy efforts to stimulate the economy are failing. As a consequence, not only did other currency markets react, but also equity markets globally as well as commodities and inflation swap markets.” [Barclays, Aug 14, 2015]

“There seems to be a big disparity between how the market and corporates sees and what the official GDP releases reveal…There are generally three schools of thoughts among China observers and market participants…

  • Chinese statistics, like those in many other emerging economies, fail to fully capture the dynamics of the service sector and so understate the size of the economy. Since the size is understated, the growth rates are then structurally overstated…
  • China’s real GDP growth trend is overly smoothed, while nominal data is of reasonable quality. That means the deflator is not sufficiently adjusted… One popular suspicion is that, just like the problem with CPI, service sector inflation is understated and so the overall deflator is understated, leading to higher real growth…This view has more solid ground…
  • Official headline growth vastly overstates actual economic growth, given the collapse of, among other things, electricity consumption growth…This statement to a large extent stems from the fact that nearly all available high-frequency indicators track the receding old economy. And, unfortunately, it is the receding part of the economy that accounts for most of the shockwaves that China is sending through the global economy.”
    [Societe Generale Cross Asset Research, Aug 21, 2015]

Financial system vulnerability

“Because the credit system has been designed around implicit state guarantees, much of the financing is misallocated to the economy’s less efficient, highly indebted sectors… Local government debt became a major test case…The National Audit Office’s first attempt to estimate the size of local government debt uncovered a stock worth 26% of GDP at the end of 2010. A second effort in mid-2013 revealed a further rise to 32% of GDP. And the latest study by the Chinese Academy of Social Sciences shows that the debt jumped sharply, to 47.5% of GDP, by the end of 2014… In early 2015, the central government announced plans to convert the local governments’ short-term, high-interest bank loans into long-term bonds. By increasing the maturity of the debt, the central government hoped to alleviate financing constraints on local governments and allow them to pursue financial stimulus. When China’s banks balked at accepting the low yields offered on the new bonds…the government forced banks to execute the debt swap. Unsurprisingly, banks suddenly became risk-averse. Local governments discovered that even with an improved liquidity position, banks were reluctant to extend new loans. Meanwhile a slump in the real-estate market deprived local governments of their main revenue source: land sales. Thus ensued one of the more shocking developments in modern Chinese economic policymaking: the government’s call for stimulus was simply ignored…”
[Frieda, Aug 19, 2015]

On the difficulties in assessing China’s actual public sector deficit and debt view post here.

A variety of indicators suggests that credit has risen to an excessive level. These include the Bank for International Settlements (BIS) credit gap measure and the high credit-to-GDP ratio in China relative to other economies at a similar income level. The credit-to-GDP ratio is still growing, albeit at a slower rate given the recent slowdown in credit flow. Official banking indicators appear healthy, but there are reasons to believe they could weaken going forward. The nonperforming loans (NPLs) ratio—albeit still low at 1.4 percent—has been rising and the sum of NPLs and special-mention loans now constitute about 5.4 percent of GDP…Deleveraging and a further slowdown in the economy could reveal more problems with credit quality, especially in the state-owned enterprise (SOE) sector—SOEs account for the bulk of corporate liabilities and their performance indicators have weakened since 2008. The equity market…is another source of financial sector risk, especially given the increasing role of margin financing.”
[IMF, Aug, 2015]

Concerns over China’s financial stability typically focus on excessive (state-owned) corporate debt, the large shadow banking sector, the huge (15% of GDP) real estate market and uncertainty over actual government debt, particularly at the local level (view post here).

China’s non-financial debt has quadrupled since, with credit quality critically dependent on the real estate sector. It is a major part of the excess global debt problem (view post here).

Against the backdrop of rapid lending growth China has experienced a housing price boom whose sustainability is critically dependence on high income growth (view post here).

Annex: IMF charts on external liabilities

CNY02

 

Sources

Barclays (2015), “China: Consequences of a new FX regime”, Barclays Cross Asset Research, Aug 14, 2015 https://live.barcap.com

Citibank (2015a), “China and the SDR: a big change in 2015”, Emerging Markets Macro and Strategy Outlook, Citibank Emerging Markets Economics team, March 12, 2015. www.citivelocity.com

Citibank (2015b), “China: beyond ‘peak reserves’”, Emerging Markets Macro and Strategy Outlook, Citibank Emerging Markets Economics team, August 21, 2015. www.citivelocity.com

Cohen, Benjamin (2015), “The Value of China’s Devaluation”, Project Syndicate, August 19, 2015. http://www.project-syndicate.org/commentary/renminbi-devaluation-reserve-currency-by-benjamin-j–cohen-2015-08

Deutsche Bank (2015). “When it rains…”, Deutsche Bank Markets Research, Asia Local Markets Weekly, August 21. 2015. http://gm.db.com

Frieda, Gene (2015), “China’s Debt Termites”, Project Syndicate, August 19, 2015 http://www.project-syndicate.org/commentary/china-government-debt-by-gene-frieda-2015-08

Goldman Sachs (2015), “Gauging China’s growth”, Asia Economics Analyst, Issue No: 15/20, June 22, 2015 http://portal.gs.com

International Monetary Fund (2015), “People’s Republic of China”, IMF Country Report No. 15/234, August 2015. http://www.imf.org/external/pubs/cat/longres.aspx?sk=43197.0

Societe Generale (2015), “China: the slowdown that matters”, Societe Generale Cross Asset Research, 21 August 2015.

Standard Chartered (2015), “CNY – Finding stability in instability”, Global Research, FX Alert, 14 August 2015.  https://research.sc.com/Portal/Login