December 5, 2011
China's renminbi (RMB) has seen some downward pressure in recent months. The People's Bank of China turned net seller of foreign assets for the first time in four years in October and FX reserves declined in September. These developments were mostly the reflection of higher global risk aversion. The outlook for China and the RMB will likely continue to be marred by uncertainty over the global economy and the eurozone crisis, leading to slower GDP growth and lower earnings for Chinese companies. Nevertheless, a sharp depreciation of the RMB or a one-off devaluation is unlikely, with the key mitigants being the relative outperformance of the Chinese economy vis-à-vis G-3 and China’s USD 3.2 tr in foreign reserves.
Explaining the decline in PBOC’s foreign assets
In October, the People’s Bank of China (PBOC) turned a net seller of foreign assets by RMB 25 bn (around USD 4 bn), marking the first time in four years that the PBOC’s net purchase of foreign assets was negative. Considering a trade surplus of USD 17 bn and FDI inflows of USD 8 bn in October, the likely explanation is that capital outflows were substantial.
A similar observation emanates from the latest data on FX reserves. In September, China’s foreign exchange reserves fell by USD 61 bn, to USD 3,201 bn from USD 3,262 bn in August. This is only the fourth time since 2004 that China saw a month-on-month decline of foreign exchange reserves. In all cases (Oct-08, Jan-Feb-09, May-10 and now), the month-on-month declines coincided with a surge in negative sentiment in global financial markets. In the previous episodes, nevertheless, the decline was only a blip, and FX reserves accumulation continued in subsequent months.
Net of central bank intervention, FX reserve changes are caused by balance-of-payment moves or valuation changes in FX holdings. Under the assumption that China’s FX reserves are still dominated by USD assets, valuation changes do not fully explain the monthly fall in China’s FX reserves.
With respect to the balance of payments, official data are only available quarterly, therefore it is difficult to track capital flows on a monthly basis. What we know is that the trade balance has remained in surplus and FDI inflows have been positive. Therefore, it is likely that capital outflows have occurred, be it FDI outflows (i.e. Chinese companies investing abroad) or outflows in portfolio or “other” investments – or a combination of those.
Global risk aversion coincides with FX reserves fall
A look at the monthly change in China’s FX reserves and the evolution of the VIX index seems to point to relatively high correlation between the two. The VIX measures the implied volatility of options on the S&P 500 index and is used as barometer of global risk aversion, often referred to as investor’s “fear gauge”. In the four episodes of monthly fall in China’s FX reserves there was a spike in VIX index, suggesting that China is not immune to capital outflows driven by global risk aversion.
Although China’s economy and domestic financial markets are relatively closed compared to other emerging market peers, its financial integration into the world’s economy has increased in recent years*. Chinese companies have been raising funds abroad through bond issuance in USD or CNH (offshore renminbi) as well as through RMB synthetic bonds (bonds quoted in RMB but settled in USD). RMB synthetic bond issuers tend to be property developers in the “high-yield” segment. When risk aversion increased in September these borrowers had to resort to buying USD onshore to fulfill their settlement commitments. This may have also contributed to the larger demand for USD in China in the September/October period.
What is the NDF market expecting?
Market expectations for the RMB/USD exchange rate as seen in the non-deliverable forwards (NDF) have reversed from appreciation to slight depreciation since late September. The current expectation is for a 1% depreciation. The NDF is a measure of currency sentiment/pressure, particularly useful in the cases of fixed exchange rate regimes, but it is not always a good currency predictor. For example, after the Asian financial crisis in 1997 and up to 2002, the NDF market signalled a substantial depreciation of the RMB vs the USD, which did not occur (see chart).
Uncertain global outlook and pessimism with regard to the sovereign debt problems in the Eurozone and the US will keep risk aversion high and USD liquidity tight. Chinese borrowers, in particular high-yield issuers, will be among those affected. Thus, it is possible to see bouts of capital outflows again which could lead to a fall in FX reserves and downward pressures on the RMB. Nevertheless, despite the large outflows, the onshore spot RMB has continued to trade in a tight range of 6.34-6.40/USD since September. This is testament to the PBOC’s exceptional ability to defend the RMB. In the final analysis, China’s superior economic perfomance, the strength of its domestic economy and the mammoth FX reserves of USD 3.2 tr are key mitigants against a sharp depreciation or a one-off devaluation of the RMB.
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