It was been just over a year since the People's Bank of China (PBOC) was instructed by Party edict to devalue the renminbi at the market close on the 2nd of August 2015. The renminbi had been trading in a very narrow range of Rmb6.19 to Rmb6.21 since April of that year. By the 22nd of August the renminbi had surged to Rmb6.4113 or 3.23%. The move sent markets worldwide into a tailspin as they scurried pell-mell to price in the new valuation, fretting the very thought of a Chinese economy heading for a hard landing the dimensions of which few even dared to contemplate. And few did: The S&P 500 lost 8.14% through the end of August. The Nikkei-225 lost 14.15%, the Hang Seng lost 15.12%, Britain's FTSE-100 dropped 10.06% and the German DAX dropped 12.64% over the period.
Since then, the renminbi has fallen another 4.04% against the dollar to Rmb6.6726 through Thursday's market close (15 September) with significantly less fanfare. Most of the decline is due to the continued poor showing of the usual myriad of economic indicators:
- China's industrial producer price index (PPI) fell 1.7% year-over-year (YOY) through the end of July, an improvement from June's 2.6% YOY slide;
- Prices at the consumer level hit 1.8% in July YOY;
- Industrial production slipped from 6.2% to 6% in August;
- Retail sales at 10.2% YOY in August nonetheless came in below expectations signaling a slowdown in consumer spending;
- Total exports fell 4.4% YOY in July on top of a 4.8% decline in June while imports fell 12.5% in July YOY on top of an 8.4% decline in June..
And then there is the issue of Chinese banks. Offshore Chinese banks have much in common with many European banks, including trading below book value, mountains of bad debt and low returns on equity-the trifecta that both pressures earnings and undermines investor confidence in bank balance sheets the world over. On the topic of non-performing loans (NPL), the official count stands at 1.75% through the end of June. The International Monetary Fund (IMF), which uses a more universally accepted definition of NPL as any past-due loan of 90-days or more, puts China's NPL burden in excess of 15% for the same period. Mainland banks are "required" to trade above book value which lowers confidence levels even further forcing market reaction to news of all varieties all the more pronounced.
Credit fueled growth has left virtually every industrial sector in the country with productive capacity well beyond current levels of demand both domestic and international. This scenario applies relentless downward pressure on investment and earnings on both the corporate side and household consumption side of the aisle. While state-owned enterprises (SOE) posted a 6.7% annualized growth rate through the end of August, the feat was accomplished in large part due to employing a range of so-called open market operations like short duration reverse repurchase contracts which effectively offers up loans to commercial banks to prop up demand in the greater economy. Such borrowing by commercial banks has significantly raised the amount of overall leverage in the domestic bond market. In a recent study by the Bank of International Settlements (BIS), China's "credit gap" or the difference between corporate and household debt as a portion of GDP growth over time is now three times the generally recognized level of sustainability. While other countries have equally elevated levels of government debts according to the study such as the euro-zone at 271%, the UK at 266% and world leading Japan at 394%, China's debt level at 255% has almost doubled since the end of 2008. It is extremely difficult for an economy to effectively and efficiently absorb capital on a sustainable basis at such a torrid pace.
Meanwhile the private sector which has been responsible for roughly two thirds of investment in the past decade slowed to about 2% through the end of July, according to Morgan Stanley data. Fixed private investment logged back-to-back declines in June and July for the first time since 2012. And since investment still drives about half of Chinese GDP growth, any slowdown of the private sector growth presents outsized concern. With both current and future earnings constrained, companies are more likely than not to be forced to increase their borrowing just to meet their maturing debt, which will place further upward pressure on the country's total debt. Overall government debt-to-GDP ratio increased to 289% through August (IIF). Standard & Poor projects worldwide corporate debt at $75 trillion by 2020 with China's share hitting 43% by that date, up from 35% through the end of 2015.
Industrial production turned around sharply in August, growing 6.3% year-over-year led by automotive sales which increased 13.1% during the month, according to government data. PMI reading for the month logged 50.4 for the month, reaching a 10-month high. Even price deflation at the producers level surged to a decline of 0.8% for the month, a significant improvement over July's 1.7% decline year-over-year. August's PPI decline is also the slowest annual rate of decline in more than four years, according to government data. Market expectations for a PBOC move on interest rates or a reduction of the reserve requirements for banks appear less in the offing through the end of the year due to August's encouraging economic results.
Downward pressure on the renminbi however remains strong as the managed mainland renminbi (USDCNY) has consistently traded to the weaker side of the free-float offshore renminbi (USDCNH) since January. Since its devaluation in August of 2015 the renminbi has fallen just over 7% against the dollar in world currency markets. After running through close to $800 billion in foreign exchange reserves defending the currency, the PBOC has managed to stabilize the renminbi-more or less. By pegging the renminbi against a basket of 13 currencies rather than solely against the dollar, the PBOC has been better able to manage a controlled decline of the renminbi by playing the currency off against either the relative strength of the dollar or the basket on any given trading day.
Of course, the 7% slip in the renminbi has come with just one 25-basis point increase in the federal funds rate in December of 2015. Arguably, the ability of the PBOC to "manage" the decline of the onshore renminbi is a function of policy options employed by the Federal Reserve. Investors playing the Federal Reserve Futures market assign a 20% probability of a rate increase on the eve of the September FOMC meeting. Offshore deposits of renminbi peaked in early 2015 and have fallen since the August 2015 PBOC-orchestrated devaluation. The signal here is mainland companies are paying down dollar- and other foreign-denominated loans on their books out of fear of further currency devaluations that heightens the risk of holding offshore accounts.
Figure 1: Yuan Interbank Rate Surges
From another forex angle, the decline in offshore deposits ties directly to carry-trade arbitrage where mainland companies exploit the artificial spread between the onshore and offshore renminbi. The mainland renminbi trades in a tightly constructed 2% range in either direction of the daily PBOC market value post. Bearish trades pour into offshore renminbi contracts in anticipation of an expanding downward spread by borrowing the renminbi equivalent in dollars overnight and selling out the position the following day, pocketing the difference. The PBOC has responded throughout the course of the year by ordering banks to buy renminbi in the Hong Kong market which soaks up excess renminbi liquidity while at the same time driving up borrowing costs. Extreme examples of this cat-and-mouse game played out in January when overnight borrowing costs spike almost 67% (see Figure 1, above). The second biggest jump in offshore overnight borrowing costs happened Monday, this time with a 24% surge. Each outsized surge in offshore overnight borrowing costs has been triggered by the PBOC to dampen speculative expectations around a possible FOMC rate increase-and a forced renminbi market slide-as a backdrop. If Wednesday's FOMC statement trends toward the hawkish side on the question of interest rate increases for the remaining months of 2016, the likelihood of renewed pressure on the renminbi and on the PBOC to further adjust its benchmark rates and/or reduce the reserve requirements for commercial banks will be unrelenting.
One further PBOC consideration is the inaugural inclusion of the renminbi in the IMF's special drawing rights (SDR), a very elite basket of the world's leading currencies used by IMF as accounting units to determine the ongoing market value of member contributions to the Fund upon which member states may draw. The renminbi officially joins the SDR basket that includes yen, the euro, the dollar and the pound on the 1st of October. The Communist Party of China through the intervention of the PBOC will undertake any and all measures to insure the event will not be soiled by unforeseen forex disruptions-large or small, domestic or international. If the Federal Reserve's hand is indeed stayed at its September meeting, the sailing for the renminbi to the December FOMC meeting and a possible federal funds rate increase will likely be choppy.
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