One of the key concerns in investment markets so far in 2016 has been China's exchange rate policy. Although the renminbi (RMB) has been relatively stable over the past few weeks, this is largely due to government intervention. According to the People's Bank of China (PBOC), China's foreign currency reserves fell by USD 99.5 billion in January, with the government aiming both to prop up the RMB and to stem rising capital outflows overseas. China still boasts the world's biggest reserve of foreign currency holdings, but the decline over the past six months has left it at the lowest level since May 2012.
A group of Nikko Asset Management's senior investment executives held a roundtable to discuss their views on the subject of China's capital flows and exchange rate policy. They focused on three potential scenarios1 that would break the current cycle of China spending its foreign exchange (FX) reserves to create currency stability, subsequently leading to increasingly bearish market sentiment when the reserve declines are disclosed. Broadly summarised, the scenarios are as follows:
1. There is a significant reduction in net capital outflows and China's spending of its FX reserves. A key factor in this outcome would be the US Federal Reserve's (Fed's) monetary policy. If it backtracks on interest rate rises and the US dollar weakens significantly, it should reverse global capital flows and allow the PBOC to stick to its basket peg.
2. Chinese authorities increase capital controls to prevent further FX reserve declines. If this diminished capital outflows and reduced reserve declines, then (as with scenario 1) the PBOC could maintain its basket peg.
3. Authorities decide they cannot stop capital outflows under their current policy and are not prepared to incur further FX reserve losses. The PBOC might move away from the basket peg and move towards its long-term goal of a free float, likely causing a large one-off devaluation in the RMB and a huge shock for global markets.
As the debate developed, it became clear that our team no longer viewed the possibility of scenario 3 as remote. In fact, some considered it inevitable if scenarios 1 and 2 failed. The opinions below are the edited highlights of their meeting.
Liang Choon Koh:
We are most likely to see a mixture of scenarios 1 and 2. From our conversations with some Chinese companies, they would certainly look to increase the hedges on their foreign debt liabilities, but not at any cost. For example, when the implied yield for FX forward hedges shot up to 20–30%, they saw no point in hedging since they don't believe the RMB will depreciate to that extent. If spot FX stabilises somewhat, then the drawdown in FX reserves due to corporate hedging flows would likely slow.
In terms of scenario 1, the Fed might not need to revert to an easing bias to see a pull back in US dollar strength. The market is already pricing in a significantly lower probability of the next rate hike, so if the Fed were to give guidance that it expects a much more gradual pace of rate rises, then that should be enough.
I think that some combination of scenarios 1 and 2 is most likely, but the downside risk of 3 could be large. My view had been that there was a very small chance of a one-off devaluation, but I now think that the probability is closer to 20%.
The issue is one of capital outflows, not of the current account. The PBOC is trying to stabilise the basket and hope that by doing so they will substantially slow the capital outflow. The question is how much of the FX reserves the PBOC is prepared to use while pursuing this policy and what it regards as a minimum level. Very little has been said about this publicly.
Yu Ming Wang:
I agree that somewhere between scenario 1 and 2 is the current base case, with scenario 3 still a low probability. However, I am interested as to why Rob thinks the probability is as low as 20%.
Although I don't think scenario 3 would be an easy route (to put it mildly), there are some benefits that I envisage. If Beijing fully opens up the capital account and allows the RMB to free float (always an elusive, stated long-term goal), then a one-time depreciation of 10–20% is likely. In that scenario, China benefits from better trade competitiveness and stability in its FX reserves. By preserving the USD 3 trillion in FX reserves and letting the exchange rate free float, then Beijing would keep the upper hand in battling the speculators.
The trouble with this scenario is that China's interest rate policy may have to stay high so that capital outflows don't become a flood. However, after a one-off 20% devaluation, I don't think that the Chinese would want to buy more dollars, although foreigners might want to buy more RMB.
So Rob, considering all these points, why is the probability not closer to 50% than 20%?
I agree with your points, but China likes to maintain control and under scenario 3 they would lose control. No one can say exactly how much the RMB would drop and there are still significant quantities of US dollar-denominated debt, so some companies/state-owned-enterprises would probably fail. It is the uncertainty around the move that would be most off-putting to authorities, particularly since past months have shown them the considerable effects of mis-reading the market's reactions.
Under scenario 3, initial movements in markets would be large. I suspect the RMB would overshoot to the downside and would present a good buying opportunity, so it might not stay depressed for very long.
If authorities did decide to go down the free float or the one-off devaluation route, I suspect they would announce rafts of financial reforms at the same time as a way of limiting the initial fall and trying to influence the market's perceptions. This appears to be the major concern of Chinese policy makers.
I agree with Rob that under scenario 3 they lose control. It is the “all-in” scenario, so if it doesn't work they would risk completely losing market confidence. Also, as Rob points out, servicing US dollar-denominated debt becomes a big problem overnight, as opposed to taking time to make this adjustment gradually. We could continue to see small devaluations, which have occurred twice since August 2015, as authorities attempt to weaken the currency.
Chia Woon Khien:
I think the ultimate choice boils down to timing. In scenario 1, the Fed back-peddling is not within China's control. Currently, China is pursuing scenario 2, which means this is their preferred choice. However, authorities are facing a real deadline – 1 October 2016, when the RMB will enter the International Monetary Fund's special drawing rights (SDR) basket as a formal reserve currency.
As we get closer to that date, if their hope for scenario 1 isn't realised and scenario 2 doesn't succeed in reducing capital outflows, then I think they would have to turn to scenario 3 – the last resort – and initiate a large one-off adjustment. In my view, scenario 3 becomes inevitable if the Fed stays its course and the 1 October deadline draws closer.
For now, with another seven months to go to 1 October, I would opt for scenario 2. I agree with Woon Khien that this scenario is most likely and that authorities would rather very firmly close the capital account than lose too many reserves. Capital outflows have been led by the reversal of huge carry trades, which are more than halfway unwound, so the worst should be over from that perspective. China could always force companies to put the remainder of these into some kind of “bad bank”, rather than unwind them hastily. I know about the IMF “rule” but I think USD 1 trillion is sufficient in terms of reserves for China, especially since it has such a huge trade surplus.
Tougher capital controls under scenario 2 should stop Chinese companies from buying overseas companies or assets (which would probably negatively affect global risk sentiment) and would likely curtail tourist spending further. The crackdown on anti-controls evasion will intensify and the SDR and capital liberalisation efforts will be de-emphasised.
If there is a major devaluation, there would be an immediate protectionist reaction to Chinese products, which would clearly hurt global risk sentiment.
Scenario 2 is clearly underway and I agree that scenario 3 is perhaps inevitable if scenario 1 does not come to pass. On the prospect of the Fed reversing course, I wonder if it would be enough to simply stop raising rates. The dollar rally began mid-2014, in the midst of the QE wind-down. I always thought that US dollar strength might be more attributable to a dollar shortage, reinforced by EM deleveraging, and perhaps only more printing would reverse these pressures.
As to the danger level of reserves that might force scenario 3, USD 3.3 trillion sounds like a lot, but it might not be if you consider the banking system, which has grown to over USD 30 trillion. Given the credit growth, I could see authorities wanting to retain as much of their reserves as possible as a buffer to a rise in non-performing loans.
I think the one-off devaluation might actually work in China's favour. Yes, it could be viewed as losing control over the short term, but the sooner authorities take that step, the more credible the level of their reserves to deal with the aftermath. I think it would act as a release valve for the economy, certainly making China more competitive, but also ending the liquidity drain that results from defending its currency. In addition, a healthy devaluation often results in new foreign direct investment.
As Rob says, scenario 3 would certainly be a global shock, with China exporting significant deflation to the rest of the world, and perhaps the Fed is finally considering reversing its monetary policy to avoid it.
Yu Ming Wang:
I think we are mostly in agreement that the probability of a large one-off devaluation, potentially accompanied by a swathe of financial reforms including a free float of the RMB, is on the rise. Fighting capital outflows by spending FX reserves may postpone the problem, but it does not solve the fundamental issue of a manipulated high exchange rate while the real economy decelerates. Allowing the exchange rate to fall and the RMB to find a new equilibrium level may actually stabilise the outflows and restore export competitiveness. In addition, if it is wrapped up with significant, achievable and credible financial reforms, this may actually turn around equity market sentiment.
As many of you have mentioned, this runs against the ethos of the Communist Party regime in terms of retaining ultimate control. However, as we have seen over the past year in the equity market, the more Beijing wants to exert control, the more it slips away. Is pragmatism going to trump ideology in Beijing? Over the past year, markets have been surprised by Saudi Arabia abandoning OPEC, the European Central Bank's “whatever it takes” approach and the Bank of Japan's latest gamble with negative interest rates. In the current environment, the Fed reversing monetary policy and the PBOC letting the RMB free float might not be so unbelievable after all.
- Scenarios sourced from Capital Flows And The Currency Endgame, Gavekal Dragonomics, 4 February 2016