For professional investors 9 December 2014 1 Chi on China Fallacies Behind the RMB Predictions SUMMARY The view that the USD105 billion drop in China s foreign exchange (FX) reserves in Q3 2014 reflected large capital outflows in turn indicating an impending sharp fall in the renminbi (RMB) exchange rate is flawed. The drop was largely due to China s FX reserve valuation effects. The argument that rapidly rising Chinese corporate debt would force a sharp drop in the RMB shows a lack of understanding of and ignores empirical evidence behind China s financial reality. It is also flawed to regard potential US rate hikes as a key factor affecting the RMB exchange rate. Fundamental factors should still underpin the yuan s mild appreciation trend in the medium-term, albeit with higher volatility. Acceleration in the opening of China s capital account or a change in Beijing s FX policy stance could change this trend, but this is not our base case scenario. Some daring analysts are forecasting a more than 8% decline in the RMB-USD exchange rate (to more than 6.6/USD from today s 6.11) by the end of 2015. In contrast, we do not think the RMB s fundamentals have changed sufficiently to warrant us changing our assessment of its mild appreciation outlook; we found that most of the bearish views were based on a distorted understanding of the currency. If it were not for the People s Bank of China s (PBoC s) intervention earlier this year, which forced a 3.4% devaluation of the RMB against the USD from its peak (to squash one-way bet on RMB appreciation), it would still be on track to appreciate by 1.5% YoY this year, as we had expected. Since the intervention, the RMB has appreciated by more than 2.0% (Chart 1). The medium-term fundamentals supporting the RMB s underlying appreciation trend in essence a basic balance surplus remain positive (Chart 2). Notably, as we have foreseen and despite it being contrary to market expectations of a decline, the current account and basic balance surpluses have improved.
Fallacies behind the RMB Predictions 9 December 2014 2 The sharp drop in FX reserves Many analysts have concluded that the USD105 billion drop in China s FX reserves in the third quarter of this year, the first decline since Q2 2012, was due to capital (including speculative) outflows. Some even argued that the drop reflected China s move to sell its large holding of USD debt. However, there is no evidence to support such bearish views. Firstly, allowing for exchange rate movements among the major currencies, China s FX reserves might have remained unchanged in Q3. In other words, the valuation effect of the reserve portfolio could largely explain the USD105 billion decline. China s central bank reports its FX reserves at face value and in US dollar terms. So even if it makes no changes to the FX portfolio composition, if the FX value of the non-usd portion falls, the headline value of the reserves will show a decline. This can be mis-interpreted as a change in the actual FX holding, effecting capital outflows and eventually putting downward pressure on the RMB.
Fallacies behind the RMB Predictions 9 December 2014 3 Research 1 shows that a large and growing share of China s FX reserves has been allocated to non-usd currencies, notably the euro, Japanese yen and pound sterling, which together account for about one-third of the total. The currency weights provided by the IMF s COFER 2 database give a proxy for the composition of China s FX reserves portfolio. Although China does not report to the COFER database, most analysts assume that China invests its FX reserves in similar proportions to those reflected by the currency weights in the COFER database. In reality, China s holding of European and Japanese assets may be larger than the shares indicated by the COFER data 3. The sharp depreciation of the euro, yen and pound sterling against the USD (by 8.5%, 8.3% and 5.2%, respectively) thus markedly reduced the value of China s FX reserves, ceteris paribus. Secondly, the US Treasury International Capital (TIC) survey shows that China s holding of US securities in the first-half of 2014 actually rose, albeit by a only USD8 billion, a tiny portion relative to its USD1.8 trillion total holding. This imperfect measure of China s holding of US assets should dispel the myth of China selling US securities as a reason for the recent decline in its FX reserves. Granted, there have been hot money outflows from China recently, but they have not been so large as to cause a sharp drop in the RMB, as some analysts have assumed. Large increase in US dollar corporate debt RMB bears have also argued that record-breaking USD borrowings by Chinese companies would force a sharp depreciation in the currency sooner or later. Some have estimated that Chinese firms raised USD196 billion worth of debt in the first ten months of 2014, more than 11 times the USD17.7 billion raised in 2008. Others have estimated that China s corporate debt swelled to 124% of GDP in Q2 2014 from 110% in 2009, and that total dollar debt had risen to USD907 billion in June 2014 from less than USD390 billion before the US s quantitative easing (QE) started. We are not questioning the accuracy of these estimates since Chinese data is imperfect. But from both a practical and a theoretical basis, the argument that a sharp RMB decline can be blamed on these dollar-debt estimates seems flawed. For example, the estimated 907 billion total USD debt that Chinese companies are said to have raised since QE began in the US amounts to about 23% of China s FX reserves. Even assuming all this debt to be short-term, it is too small (with 4.3 times FX coverage) to have any material effects on the exchange rate. Experience from previous currency crises shows that countries with total debt-to-exports of goods and services ratios of over 200% eventually hit a financial crisis point (a ratio of less than 100% is considered healthy, while 100%-200% is considered to be a critical range). China s USD907 billion foreign corporate debt is equivalent to only 75% of its total goods and services exports. Empirical evidence also shows that when a country s total interest payments-to-exports of goods and services ratio passes 20%, its debt becomes unsustainable, and financial/currency crisis will ensue; while a 1 See Best House in a Bad Neighbourhood: China s Holding of US Assets, Kent Troutman, Peterson Institute, 27 January 2014, 2 Currency Composition of Official Foreign Exchange Reserves database (COFER). 3 See A World of Known Unknowns: A Closer Look at the Allocation of China s Foreign Exchange Reserves, Kent Troutman, Peterson Institute, 24 December 2014.
Fallacies behind the RMB Predictions 9 December 2014 4 ratio below 10% suggests a sustainable debt burden and a ratio in the 10%-20% range is considered critical. Even if we assume an average and very aggressive 10% interest rate on China s USD debt, its interestto-exports ratio would only be 8%. The rapid increase in China s corporate debt is indeed a concern, but it is not yet so grave 4 that it would cause a sell-off of the RMB. China is a USD9.4 trillion economy, with total credit estimated at about 230% of GDP, or USD22 trillion. The estimated USD907 billion debt is about 4.2% of the total. This has two implications: 1) China s debt is basically denominated in domestic currency, which (combined with its excessive FX coverage of debt-servicing) reduces the odds both of a run on the RMB and of a debt crisis; 2) the USD debt exposure reinforces the need for a stable (or even a slightly appreciating) RMB exchange rate to lighten China s debt repayment obligation. The game changer So what would be the game changer to our RMB outlook? It is not the potential US interest rate hikes because the usual tool of the interest rate parity theorem for analysing capital flows does not apply to China (as we argued recently 5 ). This rational analysis relies on the assumptions of free capital flows and high substitutability between Chinese and US assets, neither of which exist in China. As long as China s capital account remains closed and the RMB s external balances remain overall in surplus, the RMB exchange rate will hold to its mild appreciation trend, albeit with rising volatility. The concerns about China s rising foreign corporate borrowings need to be monitored, but they have been exaggerated by many sentiment-driven comments 6 rather than being based on solid analysis. The ultimate game changers to the RMB s direction would be deterioration in China s external balances to an overall deficit, a rapid opening up of China s capital account or a change in the PBoC s currency stance, or a combination of these drivers. Chi Lo Senior Economist, BNPP IP 4 See Chi on China: China s Debt Conundrum (I): The money black hole & the day of reckoning, 16 October 2013. 5 See Chi Time: US Rate Hike and the Impact on China, 3 September 2014. 6 For example, see Blame Capital Flight For China s Biggest Ever Fall in Forex Reserves, Gordon Chang, Forbes, 19 October, 2014 http://www.forbes.com/sites/gordonchang/2014/10/19/blame-capital-flight-for-chinas-biggest-ever-fall-in-forex-reserves/
Fallacies behind the RMB Predictions 9 December 2014 5 DISCLAIMER This material is issued and has been prepared by BNP Paribas Investment Partners Asia Limited*, a member of BNP Paribas Investment Partners (BNPP IP)**. The content has not been reviewed by the Hong Kong Securities and Futures Commission. This material is produced for information purposes only and does not constitute: 1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever; or 2. any investment advice. Opinions included in this material constitute the judgment of BNP Paribas Investment Partners Asia Limited at the time specified and may be subject to change without notice. BNP Paribas Investment Partners Asia Limited is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Investments involve risks. Given the economic and market risks, there can be no assurance that the Financial Instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instrument(s) may have a significant effect on the results portrayed in this material. Past performance is not a guide to future performance and the value of the investments in Financial Instrument(s) may go down as well as up. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. * BNP Paribas Investment Partners Asia Limited, 30/F Three Exchange Square, 8 Connaught Place, Central, Hong Kong. ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.