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Counting on renminbi depreciation may not pay off

The view that the recent big drop in China’s currency reserves reflected large capital outflows – in turn indicating an impending sharp renminbi depreciation – is flawed.
The argument that rapidly rising Chinese corporate debt would force a sharp drop in the renminbi shows a lack of understanding of and ignores the empirical evidence behind China’s financial reality. It is also flawed to see potential US rate hikes as a key factor affecting the renminbi exchange rate.
The renminbi’s mild appreciation trend should remain intact over the medium term, albeit with higher volatility. Acceleration in the opening of China’s capital account or a change in Beijing’s FX policy stance could change this trend, but this is not our base case scenario.

The renminbi’s movement is having an increasing impact on total investment returns as it enters the “new normal” of two-way trading and higher volatility. Renminbi FX risk has finally become a reality.

The view that the recent big drop in China’s currency reserves reflected large capital outflows – in turn indicating an impending sharp renminbi depreciation – is flawed.
The argument that rapidly rising Chinese corporate debt would force a sharp drop in the renminbi shows a lack of understanding of and ignores the empirical evidence behind China’s financial reality. It is also flawed to see potential US rate hikes as a key factor affecting the renminbi exchange rate.
The renminbi’s mild appreciation trend should remain intact over the medium term, albeit with higher volatility. Acceleration in the opening of China’s capital account or a change in Beijing’s FX policy stance could change this trend, but this is not our base case scenario.

The renminbi’s movement is having an increasing impact on total investment returns as it enters the “new normal” of two-way trading and higher volatility. Renminbi FX risk has finally become a reality.

Some analysts are forecasting a more than an 8% decline in the RMB-USD exchange rate by the end of this year. In our view, this may be wrong as the renminbi’s fundamentals have not changed sufficiently to make us alter our assessment of its mild appreciation outlook.

If it were not for the People’s Bank of China’s (PBoC’s) intervention in early 2014, which forced a 3.4% devaluation of the renminbi against the US dollar from its peak (to squash one-way bet on renminbi appreciation), it would have continued on track to appreciate by 1.5% YoY last year, as we had expected (Exhibit 1). The medium-term fundamentals supporting the Chinese currency’s underlying appreciation trend – in essence a basic balance surplus – remain positive (Exhibit 2). Notably, as we have foreseen and despite it being contrary to market expectations of a decline, the external balance surpluses have improved.

Renminbi chart 1

RMB chart 2

Sharp drop in FX reserves

There is no evidence to support the bearish view that the USD 105 billion drop in China’s FX reserves in Q3 2014 was due to capital outflows. Allowing for exchange rate movements among the major currencies, China’s FX reserves might have remained unchanged in Q3.

China reports its FX reserves at face value and in US dollar terms. So even if it makes no changes to the FX portfolio composition, if the exchange value of the non-US dollar portion falls, the headline value of the reserves will show a decline. This can be misinterpreted as a change in the actual FX holding, leading to capital outflows and eventually putting downward pressure on the renminbi.

Research[1] shows that a large and growing share of China’s FX reserves have been allocated to non-USD currencies, notably the euro, Japanese yen and pound sterling, which together account for an estimated one-third (maybe more) of the total. The sharp (8%+) depreciation of the euro, yen and pound sterling against the US dollar thus markedly reduced the value of China’s FX reserves, ceteris paribus.

Granted, there have been hot money outflows from China recently, but they have not been so large as to cause a sharp drop in the currency, as some analysts have assumed.

Large increase in US dollar corporate debt

Renminbi bears have also argued that record-breaking US dollar borrowings by Chinese companies would force a sharp depreciation in the currency sooner or later. Some have estimated that China’s corporate debt has swelled to 124% of GDP now from less than 100% just a few years ago, and that total US dollar debt had risen to USD 907 billion in June 2014 from less than USD 390 billion before the US’s quantitative easing (QE) started.

We are not questioning the accuracy of these estimates since Chinese data is imperfect. But from both a practical and a theoretical standpoint, the argument that a sharp decline in the renminbi can be blamed on these dollar-debt estimates seems flawed, in our view. For example, the estimated USD 907 billion debt amounts to about 23% of China’s FX reserves. Even assuming all this debt to be short term, it is too small (with 4.3 times FX coverage) to have any material effects on the exchange rate.

Experience shows that countries with total debt-to-exports ratios of over 200% eventually hit a financial crisis point. China’s US dollar corporate debt is equivalent to only 75% of its total goods and services exports. Empirical evidence also shows that when a country’s total interest payments-to-exports ratio passes 20%, a currency crisis will ensue. Even if we assume an average – and very aggressive – 10% interest rate on China’s US dollar debt, its interest-to-exports ratio would only be 8%.

The rapid increase in China’s corporate debt is indeed a concern, but it is not yet so grave that it would cause a sell-off of the renminbi. China’s is a USD 9.4 trillion economy, with total credit estimated at about 230% of GDP, or USD 22 trillion. The estimated USD 907 billion debt is thus about 4.2% of the total. This means China’s debt is basically denominated in domestic currency, which (combined with its excessive FX coverage of debt-servicing) reduces the odds both of a run on the renminbi and of a debt crisis.

The game changer

The likely game changer to the renminbi outlook is not the potential US interest rate hikes, because the usual tool of the interest rate parity theorem for analysing capital flows does not apply to China. This rational analysis relies on the assumptions of free capital flows and high substitutability between Chinese and US assets, neither of which exist in China. As long as China’s capital account remains closed and the renminbi’s external balances remain overall in surplus, the renminbi exchange rate will hold to its mild appreciation trend, albeit with rising volatility.

The ultimate game changers to the renminbi’s direction would, in our view, more likely be a deterioration in China’s external balances to the point of overall deficit; a rapid opening up of China’s capital account; a change in the PBoC’s currency stance; or a combination of these drivers.

[1] See “Best House in a Bad Neighbourhood: China’s Holding of US Assets”, Kent Troutman, Peterson Institute, 27 January 2014

The full article is available in the Q1 2015 edition of Expert Eye on China, available here: http://publicationsystem.secure-zone.net/v2/index.jsp?id=2514/3042/9643&lng=en

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