China in Search of an Equilibrium for its Currency

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It all started in August 2015, when the move by the People’s Bank of China (PBoC) to devalue the Renminbi (RMB) by almost 2 % marked the biggest daily deprecation since 1994. Since then, the PBoC has resisted currency depreciation by using various measures to limit capital outflows, but the market continues to believe the authorities’ resistance to RMB depreciation is inconsistent with the country’s weak

Stefan Scheurer underlying fundamentals, monetary easing bias and capital account Senior Strategist, liberalization plan. Global Capital Markets & Thematic Research, Allianz Global Investors China’s currency in the midst of a Chart 1: Consensus GDP expectation may have to difficult transition be adjusted downwards going forward

Since the fixing reform, while complementary 9.0 with ongoing capital account liberalization 8.5 measures, the RMB has been in the midst of a difficult transition from a highly managed foreign 8.0 exchange regime to a more floating one. China 7.5 has been trying to go about this at a gradual pace, but that has been challenged by the rising 7.0

size and breadth of capital outflows – both from GDP (consensus %) 6.5 residents and non-residents. This was triggered by sustained uncertainty about the governments’ 6.0 foreign exchange and stock market intervention 07/12 07/13 07/14 07/15

and further disappointing economic data – China’s 2014 2015 2016 economy slowed in Q4, capping the weakest actual GDP (y/y, %) quarter of growth since the ‘09 global recession. Past performance is not a reliable indicator of future results. Source: Thomson Datastream, Bloomberg, AllianzGI Additionally, recent activity data suggest that Global Economics & Strategy, March 2016 growth momentum will likely continue to slow in Q1, so that consensus GDP expectations may have to be adjusted downwards going forward (see Focus: China in Search of an Equilibrium for its Currency

Chart 2: AllianzGI’s China GDP Tracker is pointing to a GDP China’s foreign exchange reserves are falling – growth which is closer to 5 % Entering critical territory?

20.0 However, while foreign exchange stability remains the top 18.0 priority at this juncture, it’s crucial not to maintain a stable RMB 16.0 for too long, especially as China still faces strong headwinds on 14.0 the trade front and continued capital outflow pressure. This led 12.0 PBoC governor Zhou Xiaochuan, during the Chinese New Year 10.0 holiday, to play down RMB devaluation fears and to reiterate that 8.0 the government had no intention to engineer a depreciation to 6.0 either promote exports nor growth. Nevertheless, recent official 4.0 foreign exchange reserve data – currently at USD 3.2 trillion 2.0 from a peak of almost USD 4 trillion in June 2014 – suggest 06 07 08 09 10 11 12 13 14 15 continued intervention to support the RMB (whereas part of the

China GDP (ytd, y/y, %) AllianzGI China GDP Tracker (y/y, %) decline relates to the repayment of external debt by corporates). Capital outflows are highly correlated to RMB depreciation Past performance is not a reliable indicator of future results. (see Chart 3), but the decline in foreign exchange reserves is Source: Datastream, AllianzGI Global Economics & Strategy, March 2016 also mirrored by the ongoing deterioration of global emerging market capital accounts, which were down by more than USD 1 Chart 1). AllianzGI’s China GDP Tracker is pointing to GDP growth trillion in the 12-month period until December 2015. which is probably closer to 5 % compared to the officially released GDP growth number of 6.9 % (see Chart 2), more or less in line But China’s efforts to keep the RMB stable come at a price. with the latest iteration of the Conference Board’s widely used Based on the International Monetary Fund (IMF) methodology estimates of global growth and productivity – the Conference on assessing reserve adequacy 2, our calculations indicate Board has adopted an alternative computation of China’s that China’s reserves are currently at around 130 % of the GDP as its base case1. AllianzGI’s China GDP Tracker as well as recommended reserve adequacy level (assuming a fixed Wu-Maddison estimates show a much higher degree of volatility regime)3. Reserve adequacy has been deteriorating sharply than is evident in official numbers, while there have been periods over the past few years. If China’s reserves fell to e.g. USD 2.8 when both estimates have shown GDP growth rates to be faster trillion, they would reach a reserve adequacy ratio of 106 %, than officially reported. But in the last five years (2011 – 2015), which is at the lower end of the recommended IMF range of the average GDP growth rate was estimated by Wu-Maddison at 100 – 150 % – assuming no change in money supply, exports, around 4 % (3.7 % in 2015) vs the official rate of 7.7 %. external debt and other liabilities (see Chart 4). That means that China may have only about USD 400 billion of “available” Weaker economic growth and deflationary pressure call for reserves left, which could then start to undermine confidence fiscal and monetary policy measures, but highlight the risk of in the PBoC’s ability to resist currency depreciation and manage further capital outflows and higher (financial) volatility. However, although the PBoC has aggressively cut policy rates five times and Chart 3: What about further capital outflows? Reserve Requirement Ratios (RRR) three times since 2015, there seems to be no adjustment when going into 2016 as the central 4,000 6.0 bank has managed liquidity conditions through new, more 6.1 market-based instruments like Open Market Operations (OMO), 3,800 Standing Lending Facility (SLF) and Pledged Supplementary 6.2 3,600 Lending (PSL). Hence, liquidity conditions have been broadly 6.3 constant since mid-2015, notwithstanding the impact of capital 3,400 outflows on the balance sheet of the PBoC. Going forward, the 6.4

PBoC seems to prefer short-term liquidity injection operations 3,200 6.5 compared to the large and permanent liquidity injections of the past – which may trigger further RMB depreciation –, while 3,000 6.6 room for stimulus and investment is currently more limited and 2011 2012 2013 2014 2015 the need to drive productivity via structural reforms much more CNY/USD (inverted, rhs) FX Reserves (bn USD) urgent. So we expect monetary policy makers to rely less on rate ECB PSPP Fed Hike cuts this year than in 2015, acknowledging that there is still ample room to cut e.g. Reserve Requirement Ratios, if needed, to offset Past performance is not a reliable indicator of future results. Source: Thomson Reuters Datastream, AllianzGI Global Economics & Strategy, a drain in foreign exchange reserves from intervention. March 2016 Focus: China in Search of an Equilibrium for its Currency

future balance of payments shocks. If we take the current rate of PBoC targeting a new RMB basket foreign exchange depletion since August 2015, China’s foreign exchange reserves would drop to USD 2.5 trillion or to nearly Moving on with the change in its foreign exchange regime 20 % of GDP by year-end 2016, from a current level of almost 30 % towards increasing flexibility, the CFETS (China Foreign Exchange of GDP. This would drag the reserve adequacy ratio down to 95 % Trading System), which is part of the PBoC, introduced a new (assuming a fixed regime) – below the recommended level. RMB exchange rate index in mid-December 2015, which measures the RMB’s strength relative to a basket of 13 trade- Historically speaking, credit growth can be a powerful predictor weighted foreign currencies.6 This basket was put in place when of financial crises. In an IMF sample, about one in three booms Chinese authorities signaled that, from now on, markets should is followed by a banking crisis within three years of its end.4 pay more attention to the RMB’s value relative to the CFETS According to the IMF, a necessary precondition for triggering Index rather than to the US dollar to retain some flexibility in a banking crisis, such as capital flight, is currently not in place responding to developments and in decoupling from the US in China. Household deposits are currently growing at almost Dollar. This was underpinned by the PBoC when it stated that 10 % y / y – albeit at a slower pace – whereas local household “it will maintain the CNY exchange rate basically stable at an savings remain primarily concentrated in RMB. In theory, broad adaptive and equilibrium level against a currency basket”7. In conversions of these into US dollars could raise capital outflows fact and as shown in Chart 5, the PBoC does already seem to in order to diversify Chinese household’s assets, but this hasn't be managing the RMB more closely to a basket and within a happened yet on a broad scale. reasonable trading range since its regime shift back in August 2015, based on AllianzGI’s estimated CFETS index8 (the official As Chinese authorities may have the possibility and flexibility in CFETS index is calculated based on the daily RMB-FX spot quotes their new framework as well as in their monetary policy toolkit from its platform, however, as they are only available on a weekly to maintain a certain degree of RMB stability, but also to tolerate basis. Hence, we calculated our own AllianzGI’s CFETS index continued volatility in the USD / RMB exchange rate, though, on a daily basis going back to 2014; the baseline date for our investors may continue to react much more to USD / RMB AllianzGI’s estimated CFETS index is December 2014 and the movements going forward. In that respect, the IMF is saying that baseline index value is 100 points). “China’s transition to more market-based monetary instruments, while clearly beneficial, will nonetheless not be easy, especially It is worth remembering that, back in July 2005, China in an environment that is undergoing rapid change. Therefore, announced a revaluation of the RMB and a reform of the a period of learning-by-doing will be necessary to successfully exchange rate regime, moving from a US dollar peg to a transition to the new monetary policy framework.”5 managed floating exchange rate system with reference to a currency basket. During the global financial crisis, the RMB exchange rate shifted to a soft peg to the US Dollar until June 2010 when the PBoC announced a resumption of RMB exchange rate reform. The difference: At that time there was a reference to an undisclosed basket of currencies and a modest revaluation of a currency which was widely perceived to be undervalued; now

Chart 4: China’s reserve adequacy deteriorating

450 400 350 300 250 200 150 100 50 IMF Reserve Adequacy Ratio (%) 0

01 02 03 04 01 02 03 04 01 02 03 04 01 02 03 04 01 02 03 04 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 2015 2015

Floating Fixed IMF Recommended Range

Past performance is not a reliable indicator of future results. Source: Thomson Reuters Datastream, IMF, AllianzGI Global Economics & Strategy, March 2016 Focus: China in Search of an Equilibrium for its Currency

Chart 5: China introduced a new RMB exchange rate index

106 6,1

105 6,2 104 6,3 103 6,4 102 6,5 101

100 6,6

99 6,7

Dec. Jan. Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb. 14 15 15 15 15 15 15 15 15 15 15 15 15 16 16

AllianzGI CFETS CNY Index Official CFETS CNY Index (weekly) CNY/USD (rhs) CNH/USD (rhs)

Past performance is not a reliable indicator of future results. Source: Thomson Reuters Datastream, Bloomberg, AllianzGI Global Economics & Strategy, March 2016 there are disclosed weights and a recent modest depreciation these are possible at any one time, a third needs to be given up of a currency which is widely perceived to be overvalued. (see Chart 6). So if capital is flowing out of the country, how can What the PBoC is trying to do with its implementation of the hope to maintain a stable currency and ease monetary basket is to focus on downside risk protection during the US policy at the same time? Japan's central bank governor, Haruhiko Federal Reserve’s interest rate hike cycle as well as managing Kuroda, for instance suggested in Davos that Beijing tighten the RMB against a basket of currencies, which is somewhat able capital controls to buy it monetary policy freedom. Others to mitigate the “Impossible Trinity” problem, since currency contend that China might be better off not easing monetary movements are increasingly sensitive to monetary policies and policy, since debt is already high, and just letting the economy interest rate differentials. take the pain. The third option commonly proffered, mostly by global investors it appears, is to let the exchange rate adjust.

China’s “Impossible Trinity" However, as discussed, the backdrop of weakening growth has prompted central bankers to cut interest rates to mitigate The “Impossible Trinity" indicates that a central bank cannot downside risks but has led to another challenge of managing maintain monetary policy independence, a fixed exchange the trilemma – especially at a time when the Fed is tightening. rate, and free capital movement at the same time. Only two of An environment of narrowing (real) interest rate differentials

Chart 6: China’s fight against the “Impossible Trinity”

The Impossible Trinity (Theory) The Impossible Trinity (China)

Free Capital has flowed out of capital flow China at a record pace

Only 2 goals All 3 goals are can be pursued currently being simultaneously persued

Fixed Sovereign The PBOC is still managing a The PBOC cut rates 6 times exchange rate monetary policy (soft) renminbi / US dollar peg between Nov 2014 and Nov 2015

Source: AllianzGI Global Economics & Strategy Focus: China in Search of an Equilibrium for its Currency

with the US, for instance, has led to an intensification of capital disposable income per capita by 2020 from 2010 levels, which outflows and consequently depreciation pressures on the will be challenging, e.g. considering the likely weak support from currency (see Chart 7). But that doesn't mean that Chinese external demand – historically, there has been a close negative policy-makers have no tools left at their disposal – they can resort correlation between the strength of the RMB and nominal GDP to fiscal easing. This would leave interest rates unchanged and is growth, whereas exports account for roughly 20 % of GDP. likely to boost growth, ideally accompanied by structural reforms. • Scenario 1: More control over its exchange rate, but hand-in- Chinese officials scrambled during the G-20 ministerial hand with tougher capital restrictions (basically a de facto peg meeting to restore a sense of confidence in policies and calm in to the US Dollar like we saw during the Asian crisis and the the market. Additionally, appearances by senior PBoC officials Global Financial Crisis). like Governor Zhou Xiaochuan's interview in February 2016 • Scenario 2: China immediately implements a floating Chart 7: A simple interest-rate based argument suggests foreign exchange regime via limiting its intervention to a further depreciation minimum and allowing the USD / RMB fixing mechanism to be completely market-oriented (two-way volatility) and transparent to equilibrate supply and demand. 6.0 % 6.0 4.0 % • Scenario 3: China embraces greater foreign exchange 6.5 flexibility (i.e. letting the exchange rate be more, but not fully, 2.0 % market-determined) while simultaneously imposing some 7.0 temporary administrative hurdles for capital outflows. 0 7.5 For sure, we have to acknowledge that, with a large current –2.0 % account surplus (nearly 3 % of GDP), a still high level of foreign 8.0 exchange reserves and low debt / GDP ratio compared to –4.0 % other major EMs, we believe that such fundamentals will 06 07 08 09 10 11 12 13 14 15 prevent the RMB from depreciating sharply against the US RMB/USD (inverted, rhs) 2y Bond Spread US vs. China Dollar. Nonetheless, a larger move is possible if regional currencies depreciate more than the RMB and the associated Past performance is not a reliable indicator of future results. Source: Thomson Reuters Datastream, AllianzGI Global Economics & Strategy, trade-weighted appreciation proves too much for Chinese March 2016 policymakers to bear relative to their growth and employment objectives. Overall, we view the risks to the growth, inflation and attempted to stress that China has no intention of engineering monetary policy outlook as being tilted towards the downside a depreciation for competitive purposes and that the exchange and hence for the USD / RMB skewed towards a more gradual rate will be managed to be kept broadly stable in relation to a depreciation. However, in Chinese culture, a middle way is basket of countries, among others. Certainly it was welcomed usually preferred and extremes are eschewed. The feasibility of that communications have been ramped up after a long period this middle path is contingent on three key factors: of silence and it's been helpful that the dollar has been on the weaker side, but what seems to be the most likely scenario for 1. A moderation in capital outflows the RMB going forward? 2. Domestic growth stabilization and

What is the most likely RMB Scenario? 3. Less tension and more coordination in global monetary policies of major central banks (US Federal Reserve, Chinese policy makers still seem transfixed with maintaining European Central Bank, Bank of Japan). a high growth regime, as announced by Premier Li Keqiang at China’s 2016 National People’s Congress (NPC) in March Any regime change would be undertaken when data flow is 2016. The government working report, which detailed China’s positive, market sentiment is up and markets have fully reacted macroeconomic development targets, set a target range for to the policy of the US Federal Reserve. However, while a gradual 2016 real GDP growth of between 6.5 % and 7.0 % – this will depreciation of the RMB against the US Dollar remains our most be pursued by a more proactive fiscal policy (fiscal deficit at likely scenario (Scenario 3), there are certainly risks attached to 3.0 % of GDP for 2016 vs. 2.5 % of GDP in 2015) and a target for this approach. money supply growth at 13 % (12 % in 2015). This implies that the government has maintained its plan of doubling GDP and Focus: China in Search of an Equilibrium for its Currency

No path is set in stone – Prepare for higher Understand. Act. volatility Even as the RMB is included in the IMF Special Drawing Rights In general, there are two factors at play, which are the drivers of basket, it seems likely that the internationalization of the RMB further RMB depreciation going forward: seems to have paused – there was also no mention of further RMB liberalization at the NPC in March 2016 – because China’s 1. On the one hand, the RMB is driven by external or cyclical policy makers did not want to risk more of their credibility by factors. That means a slowing Chinese economy and a devaluating the RMB sharply after that. However, given the divergence in monetary policy between the US Federal rapidly changing global environment, continued questions about Reserve and the PBoC should result, by its very nature, the currency regime, and likelihood of continued large capital in an ongoing depreciation of the RMB. Coincidently, the outflows, the risk of a more abrupt move seems to be on the rise. current strength of the US Dollar will weigh on the RMB, Moving ahead in 2016, a gradual depreciation of the RMB against hence the RMB will most likely weaken against it. However, a basket is the most likely scenario (Scenario 3). However, due to capital outflow concerns, the RMB may be stronger investors should be aware that we should be prepared for higher than the EUR, Yen and other emerging market currencies volatility to come with the PBoC itself willing to accept higher as the PBoC gives currency stability a special focus, hence two-way volatility. will likely intervene if capital outflows are huge, as we have seen in the recent past. If so, a further reduction of Chinese foreign exchange reserves is most likely. Otherwise, the PBoC would give the market more freedom in determining an equilibrium level of the RMB, finally matching fundamentals compared to market expectations.

2. On the other hand, there are structural factors at play, e.g. there seems to be huge demand from Chinese converting their local assets into foreign assets as China proceeds with its capital account liberalization. But also when looking at China’s “One Belt, One Road” program, we believe outward direct investments (ODI) from corporates are likely to gain traction in 2016 vs. foreign direct investments (FDI) and hence lead to a further diversification and reduction of foreign exchange reserves.

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Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp), Stefan Scheurer (st)

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Data origin – if not otherwise noted: Thomson Financial Datastream.

Calendar date of data – if not otherwise noted: March 2016 Further Publications of Global Capital Markets & Thematic Research

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1 The Conference Board Total Economy Database, September 2015. 2 International Monetary Fund (IMF) Staff Report; “Assessing Reserve Adequacy – Specific Proposals”, April 2015. 3 The IMF suggests a country in a fixed foreign exchange regime should have foreign exchange reserves equivalent to 30 % of its short-term external debt, 20 % of the ‘other liabilities’ on its international investment position (i.e. portfolio liabilities + other investment liabilities – short-term external debt), 10 % of its broad money supply and 10 % of its exports. The formula for floating foreign exchange regimes is: 30 % of short-term external debt, 15 % ‘other liabilities’ + 5 % of M2 + 5 % of annual exports. 4 International Monetary Fund (IMF) Staff Discussion Note 12/06; Dell’Ariccia, Igan, Laeven and Tong, “Policies for Macrofinancial Stability: Dealing with Credit Booms and Busts”, June 2012. 5 International Monetary Fund (IMF) Working Paper No. 14/75; Wei Liao and Sampawende J.-A. Tapsoba: „China’s Monetary Policy and Interest Rate Liberalization: Lessons from International Experiences”, May 2014. 6 Weights of Currencies in CFETS RMB Index: 26.4 % USD, 21.39 % EUR, 14.68 % JPY, 6.55 % HKD, 6.27 % AUD, 4.67 % MYR, 4.36 % RUB, 3.86 % GBP, 3.82 % SGD, 3.33 % THB, 2.53 % CAD, 1.51 % CHF, 0.65 % NZD. 7 People’s Bank of China (PBoC), March 2016, “RMB exchange rate remained generally stable against a basket of currencies in February 2016”. 8 According to the PBoC, the index is 102.93 on November 30th 2015, appreciated 2.93 % from the end of 2014.

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