Inside China’s FX Dice Roll

Admittedly, trying to decipher what the fuck is going on in China is a Herculean task.

That said, it’s critical that you try and get a handle on what’s going on.

Needless to say, over the past several days, markets have been infatuated with the PBoC’s introduction of a “counter cyclical adjustment factor” to the yuan fix. We’ve covered this extensively. See these posts for the background (and for a couple of laughs):

So if you want to go down the rabbit hole, those are your tickets, but here we just wanted to point out something that we think a lot of people are missing about what’s happened over the past few days.

Obviously, China has taken a step back from the August 2015 devaluation. And we mean that both figuratively and literally. They’ve for all intents and purposes transitioned back to the system that was in place prior to August 2015. That is, they’re now using the fix to manipulate the spot again. That’s led directly to a pretty epic rally both onshore and off:

Yuan

But here’s the thing you have to understand. The whole reason they devalued in 2015 was to support the economy. The gamble was of course whether that move would trigger out-of-control capital flight.

Now, the economy appears to be rolling over again, but this time around that’s not China’s main concern. At this juncture, they are effectively subjugating economic growth to financial stability. Or, more simply, if reining in the shadow banking complex and thereby curbing rampant speculation ends up hurting growth in the short-term, that’s acceptable.

What’s not acceptable however, is the possibility that the PBoC will have to add “more capital flight” to the list of fires they’re trying to put out. So what they’ve done is simply put the brakes on the currency liberalization push until they get the financial system under control.

But there’s a risk to that. Because as noted above, a weaker yuan is better for the export-driven economy, so if you start artificially making it stronger, well then you risk throwing away those benefits.

Here’s the counterpoint as delineated earlier this week by Bloomberg’s Kyoungwha Kim (full note here):

Stuck between a rock and a hard place, China is likely to strengthen the yuan in order to lure foreign capital as the liquidity lifeline to stabilize growth in the world’s second-largest economy.

Last week’s downgrade of China’s credit rating by Moody’s Investors Service highlights how the country’s leaders are caught in a quandary as they struggle to rein in leverage while maintaining the pace of economic growth. It’s getting increasingly difficult to rely on debt to fund the expansion and China’s deleveraging measures are starting to bite

For China to achieve 2017’s 6.5% growth target and keep the economy stable beyond then, it will need an external supply of liquidity

If the yuan can remain stable, China’s $16 trillion bond and stock markets could be a mouth-watering venue for global investors in the hunt for both bargains and extra yield — helping to fill the void left by China’s deleveraging drive

So that’s the gamble. Here with the flip side, and some additional color is Deutsche Bank…

Does China really want a significantly stronger RMB?

In our view, China does not want significant appreciation in the RMB. Why? First and foremost, the CNY, by our estimates, was overvalued by an average of ~8% across BEER, FEER and productivity-adjusted PPP frameworks before the recent moves. Second, the ongoing RMB appreciation could have an impact on China’s external sector. According to an NBER paper a few years ago, a 10% CNY appreciation against its REER would lead to a 13-19% reduction in exports. Given that ordinary goods account for the largest share in total exports (57%), a sizeable appreciation should have an impact.

What is the possible size of inflows if USD/CNY continues to be fixed lower? One way is to look at the flow pressure in the market. According to China’s International Investment Position as of December 2016, China foreign assets, excluding FX reserves, stood at around $3.4tn, made up of $1.3tn in FDI, $365bn in portfolio investments and $1.7tn in other investments. In our view, the flows most vulnerable to ongoing RMB appreciation at this juncture are: (1) the stock of overseas bonds with banks ($150bn); and (2) overseas FX deposits ($382bn), for a total of $532bn. In addition, we could see the unwinding of FX deposits in the onshore market, totalling about $780bn – corporates: $459bn, households: $125bn, and others: $194bn. In the offshore market, ongoing CNH appreciation could result in: 1) unwinding of some long USD/CNH positions, and (2) incentivizing the market to sell USD/CNH in the near-term to pick up carry (4-7% annualized yield pick-up, at the time of writing).This would clearly result in significant appreciation of the RMB, particularly if the PBoC were to not intervene to buy USDs.

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