Talking Point

The great escape

What does the plunge in China’s forex reserves tell us

RMB-w

Into the red: the yuan dropped 7% against the US dollar last year

In October 1997 – during the height of the Asian financial crisis – Hong Kong was hit by a substantial capital outflow which, according to the territory’s financial regulators, was caused by foreign speculators taking large short positions in the Hong Kong dollar. The outflow disrupted Hong Kong’s US dollar-linked exchange rate system. Interbank rates soared as a result and at one point the interest rate for overnight money shot up to almost 300%.

A battle to defend the territory’s currency began in earnest. It ended a few months later after the Hong Kong government splashed an unprecedented $15 billion on propping up stock prices.

Fast forward almost 20 years and Beijing is fighting another battle to stop capital from leaving the country. Volatility has spiked and in the offshore yuan market in Hong Kong, the liquidity squeeze has this month pushed borrowing costs for the Chinese currency to a historical high, with the overnight interest rate briefly reaching 110%.

As 2017 begins, we examine the renminbi’s prospects for the year ahead and look at the ways China’s regulators are battling capital flight and seeking to stop the country’s forex reserves being further drained.

The renminbi reverses

After a decade in which investors were keen to hold the Chinese currency on the expectation that it would jump in value against the dollar, sentiment has reversed sharply since the second half of 2015 when the People’s Bank of China (PBoC) announced a “one-off depreciation”.

The yuan subsequently depreciated about 4% against the dollar that year, unsettling the A-share market (see WiC292). It then lost almost 7% against the greenback last year in its biggest fall since 1994, with the majority of the decline in the final quarter as the US Federal Reserve started to raise interest rates.

The change in outlook has come at a time in which the Chinese economy has shown signs of flagging, prompting businesses and individuals to cash out of the renminbi, and creating further downward pressure on the exchange rate.

Ironically Donald Trump spent much of his election campaign accusing the Chinese of manipulating their currency, the basis of his complaint being that Beijing’s policymakers deliberately undervalued it. But for more than a year they had actually been doing the opposite by intervening in the markets to sell dollars and buy yuan. In fact, the PBoC has burned through almost $1 trillion of foreign currency to prevent it slumping further, and reserves fell to their lowest level in nearly six years in December, when they dropped another $41 billion.

After years of being revered as a formidable arsenal, China’s forex reserves are starting to look a little less imposing, and on the verge of falling through the $3 trillion level that some see as a ‘psychological’ threshold.

Opinions differ on the level at which the situation becomes precarious. Some analysts argue that more than $3 trillion is needed to defend China’s exchange rate system, while others say a smaller amount is enough if capital controls remain in place, preventing chaotic outflows.

Another concern getting coverage in the international media is that the reserves are falling drastically as a percentage of China’s money supply, which has been increasing because of Beijing’s efforts to stimulate growth and help the banks to handle corporate debt.

As supply of money grows so does the weight of capital that could flee China, putting more pressure on the reserves that remain to buffer the impact of the outflow.

At least China’s holdings seem sufficient to meet the basic minimum from the International Monetary Fund – it states that countries need enough forex to pay for three months of imports and meet their short-term debt payments overseas.

Currently China’s reserves are twice its foreign debt, six times its short-term external obligations and enough to cover more than a year and a half of imports.

Despite this, the authorities will want to reduce the drop in reserves in the months ahead. The danger is that the amount of reserves becomes less important than the story of their decline, and that market sentiment skews towards worst-case scenarios.

How has Beijing responded?

Probably the most palatable option for regulators in reducing the pressure on their currency is to make it more difficult to get the yuan out of the country. We have already reported that Chinese regulators have clamped down on its citizens buying investment-linked insurance policies in Hong Kong – which they were doing in large volumes to both get get their savings overseas and also switch into dollars (see WiC257).

But starting this year, the level of scrutiny will increase further at home, when the banks will be required to report all yuan-denominated cash transactions exceeding Rmb50,000 (prior to the change, the threshold was Rmb200,000). Similarly, gamblers arriving in nearby Macau have to work harder to arrange funding for their bets.

For Chinese citizens it will also be more of a struggle to get the quota of $50,000 in foreign currency that they are allowed to transfer overseas every year. A new application form is asking for more detailed information on why they need the cash, and it warns against spending it on overseas property and securities (approved uses include tourism, tuition, business travel and medical care, the Global Times reports).

At a company level the scrutiny of overseas investment from Chinese firms is likely to persist (see WiC347) with regulators warning against “irrational M&A activity” in sectors such as real estate, hotels and cinemas. There has even been talk that Chinese football clubs are now being scrutinised for the incredible transfer fees they are paying for foreign players such as Oscar and Carlos Tevez. This week there was also news that Bitcoin exchanges are being watched on concerns that the anonymity of the digital currency is allowing tech-savvy Chinese to cash out of the yuan and facilitate capital flight.

There will probably be more complaints from foreign firms that they are finding it harder to repatriate their profits, while China’s leaders could call on state-owned enterprises to do ‘national service’, with speculation that they will be ‘asked’ to repatriate foreign currency earnings held offshore.

Of course, the advent of more controls on cross-border capital flows (and the stricter application of existing measures) runs counter to the renminbi internationalisation agenda that policymakers have been pursuing for some time. Last October the IMF added the renminbi to the basket for Special Drawing Rights on the assumption that it would continue to become more freely tradable (see WiC342). But for the foreseeable future, Beijing seems more focused on other priorities.

Could higher interest rates help?

One of their options is to increase interest rates, making it more attractive to hold the renminbi. But an obvious challenge here, write Zhi Ming Zhang and Helen Huang from HSBC, is that Chinese companies have taken on a lot of short-term debt to finance longer-term investment. “Significantly, Rmb1 trillion or more bonds are going to mature every month from now until the third quarter of 2017. Substantially higher rates will make refinancing these bonds a very expensive exercise,” the duo warns.

Another risk is that interest rate rises would put China’s poorly regulated shadow banking sector under significant strain. In this analysis, investors have been borrowing cheap short-term money to buy bonds and other wealth management products, and then using them as collateral to borrow more and invest again. The result is escalating leverage and widening counterparty risk across an unknown (but potentially huge) spectrum of banks, brokers and asset managers.

But if the practice of defending the renminbi burns off billions more of China’s foreign reserves, policymakers may decide that leaving the currency to find its level in the market is a better approach.

How about a one-off devaluation?

A sudden devaluation might see the yuan fall by as much as a fifth against the dollar – and that would transmit a shuddering shock to the global economy, perhaps triggering a round of devaluations by other emerging market nations.

In this context, China’s leaders would need a lot of convincing that a significant devaluation would be a panacea, and not turn out instead to be a killer blow for domestic confidence in the currency.

But the option of a dramatic devaluation looks less likely in a transition year: the all-important 19th Party Congress will take place in the autumn and a leadership shakeup is expected. Thus as Xi Jinping reshuffles his senior team, Beijing will value political and economic stability in the months ahead even more than normal.

However, a controlled depreciation may move up the agenda if the Trump administration is insistent on pushing for protectionist policies against China.

That possibility has been getting more coverage in the Chinese media – Yu Yongding, a former adviser to the central bank and now an influential figure at the Chinese Academy of Social Sciences, a leading think tank, has been arguing that the authorities should even let the yuan weaken to ‘equilibrium’ level before Trump takes office this month.

Zhu Ning, a finance professor from Tsinghua University holds a similar view that letting the renminbi fall more dramatically against the dollar would be a better option than defending it ad infinitum. “The yuan has lost more than 10% [against the dollar] from its peak, but China’s forex reserves have lost almost 25%”, he told the South China Morning Post last week. “What can China do if the reserves keep shrinking… if its reserves can’t meet current account payment requirements?”

Is the yuan regaining strength?

Last week there was a clear effort from the Chinese central bank to counter the perception that the yuan is heading in a single direction against the dollar – i.e. down.

One of the outcomes was a spike in volatility as the central bank lifted the daily “fix” around which the yuan is allowed to trade against the dollar in China by almost 0.9%, the biggest increase since it was unpegged from the greenback in 2005.

In Hong Kong – where the renminbi trades freely – state-owned banks have also turned their fire on the short sellers, engineering a liquidity squeeze that saw overnight interest rates soar, deterring bears from borrowing the yuan in order to sell it short.

The tightening of liquidity helped the renminbi to post a record two-day rally offshore. It subsequently fell back (the overnight borrowing cost has fallen back to less than 3% as of Thursday, from more than 60% last week), although its run was enough for the Chinese currency to post its first weekly appreciation against the dollar for several months.

At the start of this week it again retreated in the offshore markets, suggesting that traders haven’t been discouraged from betting against it. Back in China, the central bank elected to give up most of the ground made with the higher daily reference rate, cutting it back to levels closer to the week before.

Keeping things in context…

Of course, more positive news flow about the prospects for the economy would help to stabilise China’s currency at a time in which worries over surging debt have been alarming analysts; likewise the seeming ineffectiveness of many of the government’s efforts to rein in unproductive industries and shutter so-called zombie companies hasn’t helped. Widening the analysis, mind you, shows that other currencies have been doing a lot worse against the resurgent dollar – including the pound and the euro, which have both fallen by larger amounts than the renminbi.

As Tom Holland pointed out in the South China Morning Post this week, one of the implications is that dollar strength is driving events more than yuan weakness, which must be frustrating for China’s central bank, which has spent months trying to get the markets to move away from their fixation with the dollar rate by managing the yuan against a broader basket of currencies. And against this reference group, the yuan has performed better, maintaining a more stable performance. Nonetheless, HSBC’s analysts expect the trajectory for the dollar-renminbi rate to be relatively volatile for the immediate future and their medium-term outlook of “gradual yuan weakness” remains unchanged.

“Even as less legitimate outflows are getting checked, other legitimate outflows will take place. Moreover, on the US dollar side of things, HSBC’s view is for the dollar to get stronger through the first half due to potential US fiscal stimulus, tax changes as well as trade tensions,” its analysts forecast. Changing the perception that the renminbi is a one-way (downward) bet against the dollar could be the biggest challenge China’s central bank faces in 2017…


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