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Last updated: July 29, 2015 4:07 pm

China seeks confirmation of renminbi’s arrival on world stage

Gabriel Wildau in Shanghai

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The IMF's managing director Christine Lagarde

If, 20 or 30 years from now, central banks and sovereign wealth funds hold a significant portion of their reserves in renminbi-denominated assets, financial historians will probably look back on 2015 as a turning point.

The International Monetary Fund is engaged in a year-long review of the currency composition of its special drawing rights (SDR), with a final decision expected between November and early 2016. The currencies now included in the SDR “basket” are from the world’s most influential economies: dollars, euros, yen and sterling.

If the fund decides to add the renminbi to the SDR basket, it will amount to an assurance to global central banks by the world’s foremost financial technocrats that renminbi assets are safe.

For China, inclusion in the SDR would also symbolise the arrival of its currency on the world stage alongside those of the world’s richest countries. National leaders would see it as a sign of respect for China’s increased influence in the world economy and the reforms it has taken to integrate itself with the global financial system.

“SDR inclusion could be interpreted as international recognition of China’s increased economic importance and role in global financial markets,” says Zhu Haibin, chief China economist at JPMorgan Chase.

The direct impact of SDR inclusion is almost negligible. The IMF created SDRs in 1969 to respond to a global shortage in viable reserve assets under the Bretton Woods system of fixed exchange rates. But Bretton Woods collapsed less than a decade later and today various currencies not included in SDRs, such as the Swiss franc and Australian dollar, are also widely held as reserves.

“While it appears to be a contentious issue, the Rmb’s inclusion in the SDR has little tangible and immediate economic benefit for China. The SDR is rarely used by the global financial markets and no country would manage foreign exchange reserves modelled by the SDR,” says Li-Gang Liu, chief greater China economist at Australia and New Zealand Banking Group.

But inclusion into this elite club would have real-world consequences. Every IMF member holds at least some SDRs. Thus, the inclusion of the renminbi would mean that these countries would suddenly be holding renminbi, albeit indirectly. With that threshold crossed, central bank renminbi holdings could be poised to increase rapidly.

Though there is no formal application process to join the SDR basket, China has clearly stated its desire to be included as a result of the five-yearly review now under way.

Wei Yao, China economist at Société Générale who assesses the renminbi’s chances of inclusion at about 50 per cent, says: “China, as the biggest exporter in the world, passes the first test with flying colours. It is more debatable whether the renminbi meets the second criterion.”

The main sticking point is Chinese capital controls, which severely restrict buying and selling of renminbi for investment purposes. Progress on so-called capital-account convertibility will be an important factor in the IMF’s decision.

The launch of the Shanghai-Hong Kong Stock Connect last November marked an important step towards allowing freer cross-border flows of renminbi — known as capital-account liberalisation. But the programme is still subject to a quota that caps foreign investment to a tiny fraction of overall market capitalisation.

Access to the bond market is an even greater obstacle, as bonds are the favoured assets for central bank reserve managers. China took an important step towards free usability in July, however, when it announced that central banks and sovereign wealth funds no longer needed preapproval to buy into the domestic bond market. But non-official investors such as mutual funds and individuals remain subject to quota and licensing restrictions.

“The announcement shows that the PBoC’s determination for capital-account liberalisation has not been deterred by the stock market volatility . . . and that the central bank is still promoting the renminbi’s inclusion in the IMF’s SDR basket during its next review,” said Jianguang Shen, China economist at Mizuho Securities Asia.

The IMF has never adopted specific metrics to determine whether a currency is “freely usable”, giving the fund’s executive board considerable flexibility. However, unofficial IMF working papers suggest that the fund considers whether the renminbi is, in fact, widely used for financial transactions at least as important as what regulations appear to permit or forbid.

“Capital-account convertibility is not a precondition for SDR inclusion. For instance, the yen was included in the SDR basket in 1973, but Japan liberalised international capital flows only in 1980,” says Mr Zhu.

In this regard, the fact that 60 central banks already hold renminbi among their reserves, according to Standard Chartered estimates, is likely to be viewed as an important indicator of usability. But it remains unclear how the IMF will interpret the fact that many of these central bank reserves are held in offshore renminbi assets, which are not subject to Chinese regulations.

Many other obstacles remain to the currency being “freely usable”. Individuals are still subject to a $50,000 per year limit on converting renminbi to foreign currency and vice versa. China plans to roll out a pilot programme for individual outbound investment this year, but it will still be subject to quotas.

Ultimately, analysts expect political considerations to play an important role. If the fund refuses entry to China, it could deepen the Chinese leadership’s distrust of institutions such as the IMF, World Bank and G20, which it already views as unfairly dominated by the west.

On the other hand, the US is likely to argue that the SDR is an important lever that can be used to incentivise China to quicken financial reform. IMF president Christine Lagarde has said that the renminbi’s inclusion is a “matter of when, not if”. That has led many observers to expect a compromise in which the fund will formally declare its intention to add the renminbi to the SDR — but only once deregulation proceeds a bit further.

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Last updated: July 29, 2015 4:07 pm

Battle is on for offshore renminbi market

Jeremy Grant

For a sense of how the use of the renminbi is expanding beyond China, it helps to turn to Sanchuan Holding Group, a Chinese hydropower company.

The company is not a household name outside China and probably not much beyond its home base of Hangzhou, a city in eastern China.

But it recently signed up United Overseas Bank in Singapore to handle its cross-border renminbi cash management, to support expansion beyond China.

Lin Jianhua, Sanchuan chief executive, says the Singapore bank approached his company when it learnt that the hydropower group was looking to extend its operations.

“Recognising that we needed to enhance our cross-border liquidity flow, UOB shared with us their strong understanding and insight on China’s financial liberalisation and RMB internationalisation trends, as well as on offshore RMB regulations,” Mr Lin says.

UOB, Singapore’s third-largest bank by assets, has particularly strong connections with ethnic Chinese business in the region, as it traces its roots back 80 years to the Straits Chinese, or Peranakan, who settled in Southeast Asia in the late 19th century.

It is now acting as intermediary for a next wave of outbound Chinese businesses such as Sanchuan and doing so by offering renminbi banking services as Singapore’s role as an offshore renminbi centre grows.

Sam Cheong, head of the foreign direct investment advisory unit at UOB, says almost half the companies that the bank helps expand into Southeast Asia are from China. “Increasingly, we are seeing more of them use renminbi as a settlement currency.”

In June, UOB established a “renminbi solutions team” to help companies better manage their cross-border business in the Chinese currency.

While Hong Kong remains the dominant offshore renminbi centre, China has appointed renminbi clearing banks in Singapore, London, Luxembourg and Taipei and other locations, at the same time agreeing currency swap lines with other central banks and handing out renminbi quotas.

Trade propels renminbi on route to global reserve currency

Charles Clover in Beijing

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Russia's President Vladimir Putin greets Xi Jinping, president of China. Russian companies have a keen interest in the Rmb

When discussing the internationalisation of China’s renminbi, Denis Shulakov, first vice-president of Gazprombank in Moscow, is fond of quoting Wayne Gretzky, the former Canadian ice hockey player and coach.

“You don’t need to be where the puck is, you need to be where the puck is going to be,” he says.

Gazprombank, like many Russian banks, is furiously working to set up operations in both Hong Kong and on the Chinese mainland in preparation for conducting more trade and finance in China’s renminbi: “All the Russian corporates who are key clients of the bank are moving in this direction,” explains Mr Shulakov, who says his organisation expects to be the first Russian bank to obtain a broker dealer licence in Hong Kong.

There is a good reason why Russian companies would be showing a keen interest in China’s currency for both trade settlement and finance: sanctions against Russia have frozen access to funds in the west. But for other banks and companies around the world, the reasons are just as compelling.

The past five years have seen a surge into the renminbi as a way to settle trade with the world’s largest exporter, a trend enthusiastically supported by Beijing as a means to push its long-declared goal of having a global reserve currency, commensurate with the dollar, the yen and the euro.

Already 22 per cent of China’s trade is being settled in renminbi, up from 8 per cent in 2012 and zero five years ago, according to estimates by Citi.

Bruce Alter, head of trade and receivables finance for HSBC in China, reels off a list of companies that he has worked with to do deals in renminbi: an Australian seafood exporter, a Malaysian palm oil producer, a Chinese bus manufacturer selling to Brazil and a Canadian furniture retailer.

“If you look at Rmb trade flows 2-3 years ago, it was really dominated by Hong Kong China trade, but you see today, although there is still a lot of Hong Kong in the mix, there are more companies from more markets getting into the Rmb game,” he says.

He says the main benefit of using the renminbi is that for large importers (often retailers) it is cheaper – it removes the foreign exchange margin from the contract and often Chinese companies will offer a discount of 1-2 per cent if buyers pay in renminbi.

As for overseas sellers, agreeing to trade in renminbi gives them a better chance of penetrating the Chinese market. One additional motivation is that if overseas sellers already have operations in China, they can use the renminbi export proceeds to cover their Chinese operational costs.

In addition to hubs such as Hong Kong, Singapore and London, many more countries are now also involved in offshore renminbi, with China actively promoting greater adoption of its currency in trade and finance. Central banks in countries as far apart as Malaysia, Nigeria and Chile hold part of their foreign exchange reserves in renminbi. The People’s Bank of China (PBoC) has set up dozens of arrangements with its counterparts around the world, allowing it to swap renminbi for those parties’ currencies.

“On the trade and commerce aspect, the currency is fully liberal,” says Sandip Patil, Citi’s Asia managing director for global liquidity and investments. “Any company can use Rmb whichever way they like to conduct international trade and associated working capital financing.”

He adds: “Many times you are able to negotiate larger discounts with your suppliers if you are paying in Rmb” because paying in foreign currency creates procedural bottlenecks and delays.

But compared with its surging use in trade, the renminbi still has little take-up in capital markets, despite concerted efforts by the Chinese government. This is mainly because of continuing restrictions on the ability to convert and transfer the currency.

Once it obtains a broker licence in Hong Kong, Gazprombank is keen to access what it estimates to be a $6tn pool of finance in the onshore China market through “panda bonds”, Chinese renminbi-denominated bonds issued in China by a non-Chinese issuer. “The only problem with the yuan is conversion and transfer,” says Mr Shulakov. “If you have onshore yuan you cannot freely convert it and transfer it.”

Zhou Xiaochuan, China’s central bank governor, has said it is committed to liberalising China’s capital account, but stops short of wanting the renminbi to be fully and freely convertible in capital markets transactions. In a speech in April, Mr Xiaochuan used the term “managed convertibility”.

Meanwhile, discussion with the International Monetary Fund over including the renminbi in the basket of currencies used to denominate the IMF’s special drawing rights (SDR) would open the way for reserve currency status, if the Fund gave a green light during its five year review in November. But many are sceptical that this will happen.

Dennis Tan, foreign exchange strategist for Barclays, said China has met only a few of the prerequisites for being an SDR currency and that the low usage of Rmb in international financial transactions is a potential hindrance. “In volume of trade flows and exports, obviously China has made it into the club,” he says, But in other measures, such as currency denomination of international banking liabilities and or global reserves, the Rmb still falls short, he says.

Mr Shulakov, though, is optimistic. “We are yet to experience the opening up of the Chinese local market,” he says, “but it is going to happen, inevitably. So we are in discussions and we are preparing ourselves for this, just as the Morgan Stanleys and Goldman Sachs of this world are doing.”

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Last updated: July 29, 2015 4:07 pm

Renminbi: What lies ahead?

Roger Blitz

Li Keqiang did not shirk the issue of currency wars when he spoke to the Financial Times in April.

“We don’t want to see a scenario in which major economies trip over each other to devalue their currencies. That would lead to a currency war,” said China’s premier.

Currency intervention is an issue that has chilled US-China relations for more than a decade and, while it has gone quiet of late, it is threatening to resurface.

China’s equity market shock, which from mid-June saw a wipeout of more than 30 per cent of the value of shares in Chinese companies, prompted a dramatic reaction from Beijing with regulators imposing a six-month ban on share sales by big shareholders.

As China’s economy slows, could another strident reaction be forthcoming, by depressing the value of the renminbi in order to stimulate trade, in other words a breakout of the very currency war China has pledged not to undertake?

This depends on assessing the fair value of the renminbi. The currency was pegged to the dollar until 2005, since then Beijing has allowed it to rise, except for a two-year period around the global financial crisis.

From the end of the peg to the end of 2013, it rose in value against the dollar by a third.

After the dollar hit a low of Rmb6.05, the currency pair has for the past 18 months traded in a band of Rmb6.05 to 6.27.

That, according to Aroop Chatterjee, foreign exchange strategist in Barclays, is where Beijing wants the renminbi to stay for a number of reasons.

Chief among them is Beijing’s campaign to be included in special drawing rights (SDR) the basket of currencies afforded official reserve currency status by the International Monetary Fund. A decision is expected later this year.

“Part [of the reason for the tight range] is related to the People’s Bank of China’s intention to keep the renminbi stable and a lot of that is related to the potential for destabilising capital outflows,” says Mr Chatterjee.

“But there is also the political intent on SDR. They want to project a picture of stability to the IMF and the rest of the world.”

For these reasons, several currency strategists expect the renminbi to hang around the level of Rmb6.26 by the end of the year. But Daniel Tenengauzer, emerging markets forex strategist at RBC Capital Markets, demurs. He thinks Beijing will allow the band to widen.

“Part of the internationalisation of the renminbi is a widening of the band and a more volatile exchange rate,” he says.

This opens up the debate on the renminbi’s valuation. The International Monetary Fund, in a notable statement in May, declared that it no longer believed the renminbi was undervalued.

Where the value of the renminbi goes depends on China policy. Mr Gu reckons it will rise if China accepts lower growth and opens its capital account to global investors.

But if it chooses to expand fiscal stimulus to support growth and continues to distort investment, he believes the current account surplus will shrink quickly and the renminbi will weaken.

Ying Gu, Hong Kong-based emerging markets strategist for JPMorgan, agrees, particularly as China’s current account surplus to GDP, an indicator for the currency’s valuation, has fallen to 2.3 per cent.

As the dollar strengthens through US Federal Reserve interest rate liberalisation, “I am afraid renminbi will become too expensive”, he says.

It already is, says Mr Tenengauzer. “A year ago, the currency was at fair value and now it’s 15 per cent overvalued,” he says.

Mr Chatterjee agrees. “The dollar has appreciated against the rest of the world but the dollar-renminbi pair has gone sideways. The renminbi is quite expensive,” he says.

China’s economy is showing weakness, the country faces deflationary pressures and the shock sell-off in its equity markets points to the government needing to find ways to stabilise growth and minimise risks. Cuts in interest rates are likely.

Whether that amounts to a currency war is a question of interpretation.

“In the near term, the focus is on SDR,” says Mr Chatterjee. “But further down the road, the risk to growth is to the downside. With broader dollar strength, weak growth will lead policymakers to accommodate a weaker exchange rate.

“If it was the case that the renminbi was moving because of intervention efforts, that would be different. But there are clear signs in capital outflows, in the weak economy and in weak inflation that the macroeconomic backdrop supports a weaker currency.”

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This isn’t the Chinese capital account liberalisation you’re looking for

David Keohane

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| Jul 17 10:00 | 1 comment | Share

The broad narrative of a coming capital account liberalisation in China has always bugged us. The main reason being that we couldn’t see how China, in its current state, was going to start letting money flow (easily) out as well as in.

But before we get into that we should note, somewhat counterintuitively, that China’s capital account is already fairly liberalised.

As Gavekal’s Chen Long says:

It is not at all easy to specify just how open a country’s capital account might be. The well-known Chinn-Ito Index shows that China’s capital account is among the most closed in the world, and has not opened at all in recent years. Yet this is difficult to square with the fact that total crossborder capital flows have increased by ten times over the past decade to US$1.5trn. China has a low level of de jure openness but a higher level of de facto openness.Very few types of capital flows are completely free of government control, but the partial controls still allow for a good deal of flexibility. Foreign direct investment has been largely open for decades, though there is still an approval process as well as restrictions on many sectors. Trade credit and offshore borrowing are subject to controls for prudential reasons, but they are relatively accessible for many companies. More recently, China has also simplified foreign exchange regulations to give companies more freedom in dealing with their foreign currency assets. According to the IMF’s classification, 35 out of 40 capital account items are already fully or partly convertible in China, leaving only five inconvertible.

The biggest remaining restrictions on capital flows today are on foreign currency exchange for individuals, and inward and outward portfolio investment. But there has already been fairly substantial change on this front. Today every Chinese individual is allowed to buy no more than US$50,000 worth of foreign currency from banks each year. But that limit was lifted from US$20,000 in 2007, and it is also not that hard for the more savvy to get around it.

Indeed. And if you are a less than savvy individual you might want to look into hard-to-value assets (such as art work), insurers, equity deals, Macau, brokerages, underground banks, cruise lines, and… er, “ants moving houses”. To savvy up, that is, even if we’d suggest our list is almost certainly lagging Chinese innovation where this is concerned.

Where the portfolio investment channels are concerned — mostly quota-based via the Qualified Domestic Institutional Investor and (RMB) Qualified Foreign Institutional Investor routes — suffice to say for now, as Long does, that it’s “a more nuanced tool than an on-off switch, as the quota can be increased over time as regulators get more comfortable with capital flows. Indeed, since 2012 China has significantly increased the size of the quotas for each of the channels”, including the recent Shanghai-Hong Kong Stock Connect which doesn’t apply a quota to individuals as do the QDII/ QFII and RQDII.

So we’re in a situation where China’s capital account is more open than it has been before and recent relaxations of control have increased the size and volatility of flows. Including, obviously but crucially, outflows. That makes China’s leaders v nervousand restricts policy options.

In fact, suggests Long, that’s one of the main, again counterintuitive, arguments for liberalisiation:

In fact one of the stronger arguments for further liberalization of capital flows is that the current situation is an unhappy halfway house: capital flows have become much larger, but are not very transparent. With some channels quite open but others still closed, there is much illicit use of the more open channels to disguise capital flows. For instance, companies can falsify export and import invoices, or trade finance documents, in order to move money in and out of the country. Reformers argue that it would be better for these capital flows to happen out in the open rather than underground. So the debate is not about whether or not to open the capital account, because it is in fact already partially open. The question is where to go from here.

We really like this way of looking at the issue. It’s not naive, for one.

The naive approach sees China marching towards actual capital account liberalisation. But, seriously, who thinks that is on the cards in the near term? (Or even, depending on your level of pessimism about China’s economic future, in the longer term?)

To re-re-re-iterate, this is a system that needs external capital very badly. It is happy to welcome it in, vastly less happy to see it (now internal capital?) leave. More so, it doesn’t take much to draw a lesson about attitudes to control and stability from China’s reaction to the recent stock market puke.

Long argues that the issue of CA convertibility is high on the politically important list, for both Xi and PBoC governor Zhou. And that it’s one way for the leadership to demonstrate reform. Damp squibs elsewhere need to be covered up after all.

Then there’s the SDR angle. The idea of SDR inclusion has been held up as a status thing in China and for the RMB to included in the IMF’s currency basket it has to be “freely usable”.

The reality is the decision will be more about politics and the US’s opinion on the matter — as the IMF noted previously, “there is no Board-approved set of indicators for such an assessment, nor a formal limit on the number of currencies that can be considered freely usable” and that decisions about the basket “would require judgement framed by the definition of a freely usable currency” — but here’s a chart from Cap Econ attempting to summarise China’s current position from a purely economic standpoint:

And an extra large chart covering RMB promotion from Xi et al from Deutsche for those who can be bothered clicking:

The more important political stuff is trickier to read but do remember that Jack Lew said, per Cap Econ again, on 31st March that further reforms were needed for the renminbi to qualify to be part of the SDR basket. So this could well be pushed out either way. Fwiw, Deutsche see a 40 per cent probability that the RMB will become an SDR currency in 2015, and a 70 per cent probability that this will happen by the end of 2016. We shall see.

Anyway, on we go, as this isn’t all about SDR inclusion and China needs inflows to help with its fiscal problems. Deutsche estimated in April that the size of the central government’s financing gap may be 3.7 per cent, and, to give one example, it could do with generating external demand as it launches its local government debt swap plansin ever greater style. For those keeping count, another RMB1tn is on the cards.

So, via Long, to the notion that while Zhou pledged to achieve “capital account liberalization,” he did not promise full capital account convertibility. Expect a future of monitored flows and capital controls where necessary even as China says it has opened the CA. Which should surprise nobody, tbh. Per Deutsche, “capital account openness is not a bipolar choice. Instead, it is a spectrum.”

So, as Long says, “managed convertibility” is the more appropriate likely term — and it’s not as if the world’s orthodox economic institutions, like the IMF, disagree with a cautious approach:

So what will China’s capital account look like under the future of “managed convertibility”? We think there will be three themes in the coming reforms.

First, access to domestic capital markets will be greatly increased, as separate small quotas for each investor are replaced with large quotas for all foreign investors in aggregate. The Shanghai-Hong Kong Stock Connect program marks the first step in this direction. Previously, foreign investors only had access to the Chinese financial market through an individual QFII quota. Although these quotas have been increased quite a bit, they are still not large and investors complain that the approval process is quite cumbersome. The Stock Connect program instead has a RMB250bn quota for everyone, requiring no prior approval—and the quota can be easily lifted when desired. A complementary Shenzhen-Hong Kong Stock Connect program will also be launched later this year, and we expect more such measures in the future. And in talks with the US in June, China said it would create a similar program for the interbank bond market, offering foreign investors an aggregate quota without individual limits.

Second, as China liberalizes it will try give to preference to longer-term investors who can be a stabilizing influence. A good example of this is its strategy for the bond market. We expect the domestic government bond market will grow rapidly in the coming years as fiscal deficits expand and more local government debt is restructured… This gives the government an incentive to open up of the bond market in order to find new marginal buyers of bonds. The potential is clearly very large: currently foreign investors hold just 2% of China’s onshore bond market. By comparison, India allows foreign investors to hold as much as 12% of its bond market. The People’s Bank of China said this week that central banks, sovereign wealth funds and international organizations can invest in the interbank bond market with no quota restriction, but shorter-term investors did not get the same treatment. The recent stock market crash may also lead regulators to restrict short selling and margin financing by foreign investors.

Third, restrictions on Chinese people moving their money outside the country will be relaxed, but such flows will still be closely monitored. We expect the government will lift or remove the US$50,000 annual cap on foreign-currency exchange by households. Instead the central bank will monitor the overall direction of flows and reserve the right to put on more controls when necessary. There are domestic media reports that the central bank will start pilot programs to test a removal of this limit in a few cities. In its June report on renminbi internationalization, the central bank pledged to provide an expanded channel for households to invest in overseas securities, dubbed “QDII2.” Though details are scarce, it will be easy to improve on the current QDII program which limits investors to a few Chinese funds and has not been very popular.

Taken together, these changes have major implications for financial markets: there is no question that capital flows into and out of China will substantially increase. But there is also no question that China will declare that it has achieved capital-account liberalization while retaining more restrictions on capital flows than other major economies, and that it will not meet the definition of full capital-account convertibility. This is not a criticism: we think a headlong rush to a completely open capital account would be pointlessly risky. And this “managed” approach will still get China what it wants: recognition that the renminbi is a major global currency and that Chinese financial markets are of global significance

This is all obviously educated guesswork from Long but, even if he is potentially being a bit optimistic, the broad strokes feel right.

China will want to bring money in for the reasons outlined above — and as Pettis has said it will probably succeed in doing so as yield hungry investors are attracted to RMB debt with the SDR push being used as potential cover — but it will be far more reluctant to let it leave. Really reluctant, (really) hypothetically.

Of course it remains to be seen how China’s recent attempt to save/ destroy its equity market will hit demand more broadly, but why anyone would expect any other form of liberalisation from China is somewhat beyond us.

Related links:
China’s holy trinity and the need for RMB stability – FT Alphaville
China widens foreign access to bond markets – FT
China’s plan to deal with its debt mountain – FT Alphaville
China and a friendly reminder to keep watching those capital outflows – FT Alphaville

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Making China’s FX reserves feel inadequate

David Keohane

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| Aug 26 10:32 | 1 comment | Share

Things that are not infinite include… China’s FX reserves. Even at $3.7trn.

It’s an obvious point, but maybe the point is worth remaking.

From Soc Gen’s Wei Yao:

Based on our calculations, the effective RRR rate of the Chinese banking system is actually below 15%, rather than the reported headline of 18% (include the cut today). If the PBoC were to reduce the RRR quickly to a minimum level, say 5% effectively, the amount of the liquidity injection would be over CNY13tn or $2tn, which should be large enough scope for FX intervention.

As for the adequacy of official FX reserves, the IMF has a set of metrics for assessment, depending on: 1) the currency regime (fixed or float); and 2) the degree of capital controls. The most stringent requirement applies for an economy with a fixed currency but no capital control. Given the rapid capital account liberalisation since 2010, China’s current situation is probably not very far from that situation. In this case, China’s FX reserves are still 134% of the recommended level, or in other words, around $900bn (1/4 of total) and can be used for currency intervention without severely impacting China’s external position.

From an operational perspective, China’s FX reserves are estimated to be two-thirds made up of relatively liquid assets. According to TIC data, China held $1,271bn US treasuries end-June 2015, but treasury bills and notes accounted for only $3.1bn. The currency composition is said to be similar to the IMF’s COFER data: 2/3 USD, 1/5 EUR and 5% each of GBP and JPY. Given that EUR and JPY depreciation contributed the most to the RMB’s NEER appreciation in the past year, it is plausible that the PBoC may not limit its intervention to selling only USDdenominated assets.

In a nutshell, the PBoC’s war chest is sizeable no doubt, but not unlimited. It is not a good idea to keep at this battle of currency stabilisation for too long.

So it’s not about size, it’s about “adequacy”, a relative measure. Headline size alone won’t cut it. And, considering that, there is a good reason that China might get nervous about its reserve levels.

As Wei Yao says, it’s the currency, and, as Citi say, the idea that the “prospect of further exchange rate depreciation should boost capital outflows”.

From Citi on just that:

The reason why outflows accelerated after Q1 2014 is that a good deal of capital inflow had been attracted to China during a period when the nominal exchange rate’s path encouraged firms and households to be short-USD-long-RMB. Once the stability of the RMB had been shaken, the incentive to remain shortdollars eroded. And that incentive is even weaker now in the wake of last week’s move by the PBOC to flexibilise the exchange rate, since it is likely to have the effect of fuelling further expectations of currency depreciation – our own forecast is for CNY/USD at 6.8 – and this increases the attractiveness of being long-USD.

The combination of Chinese monetary easing and US monetary also help to push capital from China, just as it was pulled into China in recent years. It wasn’t only the RMB’s predictability in recent years that sucked in speculative flows, but also the relative cheapness of borrowing in USD. One way of looking at this is contained in Figure 3, which shows BIS ‘international claims’ data that suggest China’s cross-border debt to banks rose from less than $200 bn in early 2009 to over $1 trillion by mid-2014. This is only a partial picture of Chinese borrowing, because it doesn’t account for all of the securities that Chinese firms have issued in recent years. (BIS data show that Chinese national borrowers have issued $455 bn of securities in total – almost all of which was issued in the past five years – though the bulk of this was issued by offshore entities). The important point here is that the stock of foreign debt is still to be repaid: the capital outflows depicted in Figure 1 represent something other than substantial debt repayments. Sure, Figure 3 suggests that the repayment of China’s foreign bank debt has begun, but there is still a stock of fx liabilities that’s nearly $1 trillion in size.

There may also be a structural reason to expect further capital outflows. The end of the ‘one-way-bet’ in the fx market is not the only reason to expect capital outflow. In recent decades, China has seen its wealth grow at a faster rate than it has acquired an internationally diversified portfolio of assets. For much of this period, it didn’t matter that wealth had been accumulated overwhelmingly in RMB, since the RMB was so obviously undervalued that the incentives for international diversification were weak. Moreover, capital controls have been in place, so both Chinese firms and households had both limited willingness and limited ability to diversify. Both those factors have changed, though: the RMB is no longer obviously undervalued, and capital controls are in the process of being dismantled. So China’s demand for foreign assets should be expected to grow, as it would naturally as China gets wealthier (Figures 5 and 6). Of course, the acquisition of foreign assets doesn’t necessarily imply a depletion of fx reserves. But it is likely to push in that direction, we think.

Again, we think most of this is now well understood. But the reserve adequacy point might be worth underlining — China’s published foreign reserves in USD have fallen in headline terms by $340bn since June 2014.

Taking valuation changes (probably accounting for under 70 per cent of China’s reserve losses over the last while) and the restructuring of China’s fx assets (via injections into policy banks for example) into account, Citi ask: how far can the PBOC afford to see reserves fall?

As we see it, there are two possible concerns that could result from large losses of fx reserves from the PBOC. One has to do with the market’s perception of China’s financial stability, or, put another way: how far can China’s reserves fall before market participants foresee a rise in country risk? Another possible concern is the link between reserves adequacy in China and overall monetary conditions in China; in other words: can reserves loss lead to a tightening of monetary conditions and hence become a risk to growth?

There are reasons to question the robustness of China’s reserves adequacy. Although $3.7 trillion sounds like a lot, it is possible to demonstrate that China’s level of fx reserves is in fact not that robust. To show this, we apply a methodology based on the IMF’s Assessing Reserves Adequacy framework1 . The Fund’s approach is to proceed from the basis that a country should have enough reserves to cover 30% of short-term external debt; plus 5% or 10% of exports (5% for those with floating fx regimes; 10% for those with pegged currencies); plus 10% or 15% of external portfolio liabilities (the bigger number is for those with fx pegs), plus 5% or 10% of M2 (again, the larger number is for those with fx pegs). This sum is a ‘metric’ that the IMF uses to benchmark the adequacy of fx reserves in different countries. And for China, the ‘metric’ indicates that the PBOC should have at least $2.6 trillion in reserves. In practice, the IMF suggests that a country’s reserves should be at least the sum of these numbers, and that the adequacy requirement is met as long a country’s reserves lie between 100-150 percent of the metric defined above. So, with $3.7 trillion in reserves, China’s reserves are close to that 150% ‘ceiling’. But Figure 9 shows that by EM standards China’s reserves adequacy is low: only South Africa, Czech Republic and Turkey have lower scores in the group of countries we examined.

Of course, as Citi note, concerns about reserve levels should be balanced by the presence of (receding, for now) capital controls and the search for reserve currency status, SDR inclusion.

On the former, from Citi again:

The idea is that if there are controls in place which inhibit outflows, then fewer reserves are needed. The Fund’s July 2015 External Sector Report2 suggests that when adjusting for China’s capital controls in this way, its reserves adequacy is 238% of the ‘metric’, instead of the near-150% shown in Figure 9. We have no cause to dispute the IMF’s reasoning, but since China is in a process of dismantling capital controls, the effective ‘cushion’ that is created by the presence of controls will weaken over time.

And on the latter:

But equally, the need for plentiful reserves should be reduced over time by the RMB’s emergence as an international reserve asset – a path on which SDR inclusion will be an important milestone. Put simply: once a country can print a currency which is internationally accepted as a store of value, then its need for precautionary holdings of other countries’ reserve currencies will fall.

Er, yes. Let us know how the gap between now delayed SDR inclusion and the current (and yes, stress that) reality of reduced capital controls goes.

Anyway, h/t goes to Balding, who also recently wrote about this.

More, including a discussion of the FX reserve-growth connection, in the usual place.

Related link:
Questioning China’s reserves with Charlene Chu — BI

http://ftalphaville.ft.com/2015/08/28/2138825/chinas-ongoing-fx-trilemma-and-its-possible-consequences/

From UBS’s Tao Wang on what, post China’s surprise revaluation, is now an oft used phrase, the impossible trinity — AKA the corner China finds itself in:

The impossible trinity says that a country cannot simultaneously have an open capital account, independent monetary policy, and stable tightly managed exchange rate. Some academics (such as Hélène Rey) argue that since capital controls are no longer as effective in the current day world, complete monetary policy independence is still not possible without some degree of exchange rate flexibility, even without a fully open capital account – or impossibly duality.

Regardless of whether it is an impossible trinity or duality, the fact is that in recent years, as a result of substantial capital controls relaxation, China has found it increasingly difficult to manage independent monetary policy while simultaneously maintaining a fixed exchange rate. Since last year, the PBC has had to repeatedly inject liquidity and use the RRR to offset capital outflows – its efforts to ease monetary policy have been less effective because of FX leakages, while at the same time rate cuts are reducing arbitrage opportunities to add further downward pressures on the currency (Figure 15). As China’s government has announced and seems to be committed to fully opening the capital account soon, these challenges will only become greater. Therefore, it is the right thing to do to break the RMB’s dollar peg and move to materially increase its flexibility.

At the moment, China’s weak domestic demand and deflationary pressures necessitate further interest rate cuts, which may further fan capital outflows and depreciation pressures. Meanwhile, not only is the RMB’s recent effective appreciation still hurting China’s tradable goods sector, but the central bank’s defence of the exchange rate is also draining substantial domestic liquidity that necessitates constant replenishing, both of which is undermining the effectiveness of overall monetary policy easing.

With a more flexible exchange rate, the RMB can be weakened by outflows and depreciation pressures without draining domestic liquidity, and domestic assets will become relatively cheaper and thus more attractive than foreign assets – which may ultimately alter market expectations to reduce capital outflows. In addition, a weaker RMB should improve China’s current account balance to also alleviate depreciation pressures. Conversely, if China’s exchange rate is allowed to appreciate along with capital inflows and appreciation pressures, it will make domestic assets more expensive and less attractive, to ultimately worsen China’s current account balance.

But, everything has consequences, TANSTAAFL etc…

And one of those, considering the trilemma, is that China might have to backtrack on its moves to open capital controls. Particularly as SDR inclusion has been pushed back.

As Citi said before — while discussing the adequacy, or otherwise, of China’s reserves — “if there are controls in place which inhibit outflows, then fewer reserves are needed…but since China is in a process of dismantling capital controls, the effective ‘cushion’ that is created by the presence of controls will weaken over time. ” Which is fair.

In China’s defence though, what’s also fair is that “the need for plentiful reserves should be reduced over time by the RMB’s emergence as an international reserve asset – a path on which SDR inclusion will be an important milestone. Put simply: once a country can print a currency which is internationally accepted as a store of value, then its need for precautionary holdings of other countries’ reserve currencies will fall.”

But, as we noted, when quoting them the first time, SDR inclusion is now delayed and we wonder if that means the capital controls position will have to change? Perchance to do so now officially will be too embarrassing? Perchance they might start by coming down harder on unofficial channels?

We shall see, do keep an eye on China’s underground system, you know, like “ants moving houses”, Macau and other such outlets.

Back to TW:

For either capital account or current account channels to work to give monetary policy sufficient room to cater towards domestic need, the exchange rate has to be sufficiently flexible and market forces must be allowed to play a sufficient role.

But will the Chinese government allow the exchange rate to move sufficiently? If the market believes the RMB needs to depreciate by 10% and the government intervenes to stop it, expectations will only worsen. Will the PBC then sacrifice its interest rate and monetary policy independence to stabilize the exchange rate, or vice versa? If the former, then the whole purpose of China’s exchange rate move – being greater interest rate and liquidity policy independence – is lost. It is also not wise for a large economy to give up its monetary policy independence, given the different issues and economic cycles it will have to face as a result of upcoming changes in the US. If the later, then domestic political pressure from groups with large FX exposures will likely increase; as global pressure and trade protectionism against Chinese products likely rise too. In addition, the internationalization of RMB may suffer a nominal set back as fewer people would want to hold RMB assets, causing offshore RMB deposits to decline.

If the government wants to maintain both relative stability of the exchange rate and monetary independence, realistically it cannot do so without capital controls. Its recent RMB move has made this painfully clear – since August 11, the central bank has spent more than $100 billion trying to prevent further RMB depreciation (Figure 16), according to market estimates. At this pace, even China’s $3.7 trillion in FX reserves will not last that long before confidence weakens further and domestic political pressures rise as a result of heavy losses in the country’s reserves. In addition, selling large amounts of China’s FX holdings and US or other government papers could also raise international concerns.

The dilemma faced by China’s government is clear. Assuming that China wants to preserve monetary policy independence, it has to either let the exchange rate adjust more freely and substantially, or use the capital controls it has by tightening them. The latter could include seeing through the proper implementation of documentation requirements supporting FX purchases (which have relaxed in the last couple of years), tightening risk controls on corporates, and placing reserve requirements on FX holdings. However, tightening capital controls goes against the government’s stated objective of full capital account convertibility and RMB internationalization ambitions, and could also invite criticism or accusations that China is backtracking on reforms. That said, in our view, neither is using the so-called “market-based intervention” – spending reserves to defend the exchange rate at overvalued levels against market pressure – really a viable solution.

Given this dilemma, while in the midst of dealing with a protracted economic slowdown driven by an ongoing property downturn and high leverage levels, it is not surprising why many China watchers and investors are puzzled by the government’s continued pursuit of capital account opening.

Fwiw, TW is betting on more depreciation and tightening of existing capital controls — that’s not exactly what she thinks they SHOULD do, of course, but constraints are constraints even for China:

What path will China’s policymakers take in the coming months? Given that the real economy still faces persistent downward pressures, corporates are struggling with a very high debt burden and still very high real interest rates in a deflationary environment, and exports continue to suffer from the past couple of years’ of RMB appreciation, we think China should ease monetary conditions further and let its exchange rate depreciate more substantially. To stabilize expectations and avoid too much overshooting and volatility, the Chinese government should depreciate the exchange rate quickly and unexpectedly before increasing the flexibility of the exchange rate, and at the same time tighten capital controls.

However, given the aforementioned trade-offs in its policy options and the Chinese government’s desire to maintain exchange rate stability while pursuing internationalization-related reforms, we think the more likely outcome would be that the PBC continues to defend the RMB for a while using FX reserves, before resorting to tightening existing controls and slowing further capital account opening. This may not prove to be very effective as the exchange rate has not been allowed to adjust sufficiently. Sometime next year we could see RMB being allowed to depreciate by another 3-5% depreciation against the USD, which if not managed well could serve to further entrench depreciation expectations.

Based on the above analysis, we maintain our end year USDCNY forecast of 6.5, but revise our end-2016 forecast from 6.6 to 6.8, and see FX reserves falling by more than $500 billion by then. As a result, we expect the PBC to further cut the RRR in the rest of 2015 and in 2016 (by at least 250-300bp if no other liquidity tools are used), while also using other liquidity facilities to ensure accommodative monetary conditions in China.