The renminbi fell by 5.71% year-on-year (YoY) against the US dollar in 2018 on concerns over slowing domestic growth clouded by domestic debt reduction efforts, a trade war with the US and a shrinking current account surplus (estimated at only 0.8% of GDP for full-year 2018). Financial markets are predominantly bearish on the renminbi, with many participants expecting it to weaken beyond 7 per USD in 2019.
Why am I still going for a renminbi appreciation then? My view is that markets are overly bearish on China’s balance of payments position, underestimating the financial account inflows and exaggerating the fears over capital outflows.
Capital flow dynamics
The flow support for the renminbi from the current account has dwindled along with the surplus. Net foreign direct investment (FDI) inflows have also dropped. Hence, the estimated basic surplus has dropped to below 1% of GDP (Chart 1). Many market participants are forecasting a current account deficit this year.
However, China’s external balance may not be so bearish.
- Firstly, China has accelerated the opening-up of its markets to foreign investment and has pledged to improve its behaviour on structural points of contention such as industrial production protection and forced technological transfers. Combined with still-stringent capital controls, this may boost net FDI inflows.
- Secondly, a slowing economy will constrain China’s imports and slow the growth of its services trade deficit by slowing outbound tourism. Meanwhile, it has diversified its exports beyond the US to other countries, notably the Belt & Road Initiative (BRI) countries (Chart 2). So, export growth in 2019 may not drop, or at least not by as much as the market expects in view of the Sino-US trade dispute. All this should help keep the current account and basic surpluses from further erosion, or even boost them.
Outflows: not as bad as they might appear
The capital outflow pressures have been exaggerated, in my view. After adjusting for exchange rate changes, non-FDI outflows, which represent both hot money and illegal capital outflows, have actually been reversing recently instead of worsening as the unadjusted data shows (Chart 3). They amounted to USD 156 billion in 2017 and USD 597 billion in 2016 when capital outflows were rampant.
In a nutshell, current account and FDI flows may not be as strong a support for the renminbi as before, but the flow dynamics may also not turn as negative as consensus would have it.
Improved sentiment, index flows equal renminbi support
So, the pivotal question is about financial account flows, and this has much to do with market sentiment on China. The impact of Beijing’s policy easing on market sentiment is starting to show in the recent recovery in the CNY-USD cross-rate and the drop in China’s bond yields. The decline reflects market sentiment turning from worrying about defaults (which pushed up yields) to cheering disinflation (which has recently pulled yields down).
The move by international equity and bond index service providers to add Chinese assets to their international emerging market indices should boost sentiment, bring more portfolio inflows, and as a result, support the renminbi. This flow impact on the exchange rate has proven to be significant. Portfolio investment flows accounted for over 90% of China’s financial account surplus in H1 2018. They kept the renminbi strong against the US dollar despite China’s current account deficit in Q1 2018 and rising Sino-US trade tensions (Charts 4 and 5).
Adding to private-sector inflows are global reserve managers’ asset allocations to China. The renminbi’s share in global currency reserves has doubled from 1% to 2% since 2016 and its weight is now bigger than that of the Australian dollar and the Swiss franc (Charts 6 and 7). If global reserve managers increase their renminbi assets by an average of 0.5 percentage points a year, USD 40 billion would flow to China’s onshore bond market.
Finally, easing Sino-US trade tensions, which look increasingly likely in 2019, will most probably help improve renminbi sentiment and also boost financial account inflows to China. If the US dollar weakens, as an increasing number of market participants now foresee due to a potential change in the US Federal Reserve’s interest-rate policy, that can also support the renminbi. I thus believe there is a fair chance that the renminbi will appreciate against the US dollar on a year-on-year basis (by about 3.5% would be my estimate) this year.
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 See “Chi Flash: Sino-US Trade Negotiations (I): Odds Have Risen For Cooling Trade Tensions”, 7 January 2019, and “Chi Flash: Sino-US Trade War: Truce For Now But Risks Have Mutated”, 3 December 2018
 One market study estimated that a 50bp rise in China’s GDP growth rate would cut its current account balance by 1.5%. See “Global Macro Strategy: Asia FX 10 Questions for 2019”, UBS, 5 December 2018, pp.6. This argues that slower growth in China should boost the current account surplus.
 They are estimated by subtracting China’s current account balance and net FDI flows from the change in FX reserves.
 MSCI is conisidering raising the inclusion factor for Chinese A-share in its EM index to 20% from the current 5%. The decision is due by the end of February or early March this year. FTSE Russell announced last September that it would include 1 200 A-shares in its FTSE Emerging index in three stages, starting from June 2019, bringing in more than USD 50 billion of passive inflows to the A-share market in 2019. In fixed income, Bloomberg/Barclays are going to include all CGBs and policy bonds in its Aggregate Bond index over 20 months, starting April 2019. This is expected to bring in USD 110 billion of inflows. Citi WGBI and JPM GBI-EM intend to include Chinese bonds in their indices later this year or early 2020. This would bring in an average of USD 80 billion a year between 2019 and 2020, according to market estimates.