Commerzbank:
China’s central bank is losing forex reserves at an alarming pace. To ban any dangerous discussion about reserves, the Chinese government allows the yuan to depreciate moderately and urges businesses to scale back their exodus of capital. If, however, this mix of measures does not work out, the government will soon face a tough decision: It will either have to let the yuan depreciate sharply or impose explicit restrictions on capital flows.
China’s exchange rate policy will thus keep markets on edge. China’s FX reserves are high but quickly shrinking … At $3.231 trillion the People’s Bank of China’s foreign exchange reserves are still extremely healthy – no other central bank has anything like this much. Moreover, measured by the standards applied by economists to assess whether reserves are appropriate, the PBoC is holding far too much in foreign currency assets. However, in January alone, the PBoC’s foreign-currency reserves fell by some $100bn, having declined by 19% since their peak in August 2014.
Even worse, the pace of decline has been accelerating since the end of 2015 (chart 1). It is obvious that this situation cannot be sustained. If nothing changes, even the large PBoC reserve portfolio will disappear at some point. By that point it would no longer be possible to support the currency via PBoC forex sales, and the renminbi would plummet. A halfway efficient forex market will anticipate this happening, so that pressure on the currency to depreciate increases well in advance. A downward spiral might thus quickly develop. Shrinking forex reserves could trigger greater downward pressure, which in turn – if the central bank continues to shore up the currency – further eats into the reserves. … because the central bank is funding the capital outflow
Why has the PBoC been losing forex reserves recently? The answer lies in China’s balance of payments, the account of financial transactions conducted with the rest of the world (chart 2). The net financial account (ex reserves) in particular has changed. It used to be positive, except for a few quarters, showing a net influx of capital from abroad into China. Since 2014, however, the balance has grown increasingly negative, indicating that China is now a net exporter of capital.
What does this have to do with the central bank? If a Chinese individual acquires receivables abroad, for example in the form of dollar assets, either another private Chinese entity will give him the dollars (which would have no effect on the aggregate financial account) or they come from export proceeds or from the central bank’s reserves.1
. The gap is being bridged by the Chinese central bank selling its forex reserves. Available options to halt the reserve selloff What can China’s government do to put an end to this untenable situation? Basically, there are three options: sudden, massive devaluation; gradual devaluation or clear restrictions on crossborder capital flows. First: Deregulating exchange rates Following the gradual depreciation of recent years, many observers now expect a major devaluation step that would put an end to devaluation once and for all. In this situation, it is irrelevant whether such a move were managed by the PBoC or whether it resulted from a sudden shift to fully flexible renminbi exchange rates.
If China’s currency fell so sharply that no one envisaged any further depreciation, the downward spiral would be ended. The logic behind such a step is straightforward, but it would be a risky experiment. Sudden massive renminbi depreciation would make imports far more expensive, causing them to slump. As a result, production chains could be interrupted without any domestic substitutes being readily available. The outcome could be a severe recession. What is more, CNY exchange rates would no doubt overshoot, as the recession would make investment in Chinese assets more risky, thus forcing more capital out of the country.
This in turn would trigger another round of depreciation. Second: Gradual depreciation If speed is the problem, then perhaps a slow approach is warranted? Gradual CNY depreciation would have a slower impact on imports. The economy would have time to adjust, for example by building up new production chains to replace imports with domestic products. Damage to the real economy could be contained. Yet it is difficult to manage gradual depreciation. Any half-way efficient foreign-exchange market should soon recognise the strategy which is being applied. The expectation of further CNY depreciation would at once accelerate the outflow of capital, thus increasing immediate pressure on the currency.
Third: Slowing the capital outflow However, the government does have direct means to slow the outflow of capital. It could in theory start to reverse the gradual liberalisation of cross-border capital flows, implemented over the past 15 years or so. Yet there is another option too. An autocratic regime can quietly introduce measures to hamper capital flows, for example via stricter regulatory barriers or making administrative procedures more onerous. A smaller capital exodus would mean less of a problem financing it. Also, the domestic side effects could be reduced. If capital leaves the country too quickly, domestic capital markets come under stress. The recent equity market selloffs may have been a harbinger of this. A slump on the property market would have more serious consequences for the real economy, and the regime in Beijing will no doubt do all it can to prevent this happening.
Most likely scenario: muddling through will continue To ban the perilous discussion about reserves, China’s regime is adopting a mixed strategy that includes moderate depreciation as well as an imperceptible reigning-in of capital outflows. The results of moderate depreciation steps are already visible: While exports have continued to do fairly well, imports have shrunk substantially (chart 3). The trade surplus is reaching all-time highs, and with it the current-account balance.
Nevertheless, the increasing income from net exports still is insufficient and cannot finance the capital outflows that are increasing due to increasing depreciation expectations. In between phases of depreciation, the PBoC is therefore ensuring phases of relative exchange-rate stability, and with some success. Dollar-renminbi risk reversals, which can be taken as a market-based indicator for the risk of further large devaluation steps, have always risen during periods of depreciation, but have subsequently always fallen again (see chart 4). Many regard this alternating PBoC approach as inconsistent, but it could equally be viewed as fairly successful muddling through. This strategy devours a large volume of foreign currency reserves, though, especially for the PBoC’s attempts to calm down markets. Consequently, the government is forced to rein in the Focus capital exodus.
Its solution, for obvious reasons, is a quiet approach. If it openly revised the deregulation of capital transactions, this would be tantamount to admitting that its policy of the last 15 years had failed. Beijing’s rulers will want to avoid creating this impression, especially since quiet steps can also be effective. After all, it is relatively easy for the government to enforce regulations in the corporate sector, and most capital leaves the country via the corporate sector. Restrictions hampering foreign-currency purchases for hedging purposes have already been introduced. There are reports, too, of further efforts such as reining in CNY/CNH arbitrage. And the propaganda machine is also running, with denunciation of “speculation” against the renminbi.
Such measures can be perfectly effective in an autocratic regime. In our view, a policy of muddling through could well prove successful. On the one hand, the rising current-account balance can finance more and more of the capital exodus, and on the other, this will be slowed down by muted restrictions. It is fair to hope that a balance can be achieved before foreign-currency reserves fall so far that a downward spiral is triggered. But the strategy does have a price: Placing obstacles in the path of open cross-border capital flows will render corporate investment policies less efficient.
And the capital confined to the country will ultimately perpetuate the domestic over-investment problem. Ugly decisions if muddling-through fails What if muddling through doesn’t work? In that event unpleasant decisions would have to be taken. But rather than risk a collapse of the exchange rate and a sharp recession, the government would prefer to place stronger, more visible restrictions on capital movements. In situations of this kind, the political loss of face is generally alleviated by blaming “evil speculators”.
Propaganda usually places these offenders abroad, so that the change of political course is not seen as an admission of the government’s own mistakes, more as a matter of national endeavour. We have frequently observed such mechanisms on the part of politicians of all persuasions – Mexico in the 1980s, the UK in the early 1990s, Malaysia in the middle of that decade, and Russia, are just a few examples. What it all means for the exchange rate Consequently, we expect renminbi to devalue further but without plummeting. We consider it likely that USD-CNY will gradually rise until just short of 7.00 rather than reaching extreme levels far beyond this level.
