By Hayden Briscoe
Even before the recent correction in China's A-Shares market, a number of investors had expressed skepticism about our positive outlook for the renminbi (RMB). Some even saw a devaluation as a possibility. For a variety of reasons, we continue to see the currency appreciating.
Investor skepticism about our outlook for the currency has only intensified since the recent market pullback, amid broader doubts about how effectively China is pursuing its goal of becoming a more open, market-oriented economy. We think such concerns are understandable, but that they need to be kept in perspective.
There is a tendency to see the eventual inclusion of the RMB in the Special Drawing Rights (SDR) basket of the International Monetary Fund (IMF) as a measure of the currency's progress toward full internationalization.
Until recently, expectations were strong that the RMB would be admitted to the SDR in November, but since the market correction those expectations have evaporated, largely on the assumption that the IMF will want to wait with regard to taking further action until clarity has returned to the outlook for China's markets and reform program.
We think this perspective is distorted, but here's the twist: we agree that the RMB is unlikely to be included in the SDR this November, but for a different reason - President Xi's visit to the US in September. Talks with President Obama will cover bilateral trade agreements - a particularly important issue for China, which has been excluded from the Trans-Pacific Partnership trade agreement, now under negotiation between the US and several Pacific Rim countries.
Given the degree of influence that the US and its allies have within the IMF, we believe it's likely that the RMB's inclusion in the SDR basket will be held over until next year, or at least until after the US-China talks reach an outcome that both sides can support.
China Eyes the End Game
Our own perspective on the RMB is shaped by its fundamentals and by our conviction that China's reform program remains on track for the long term. The RMB has become the second most used currency for documentary credit transactions (such as letters of credit), ranks fifth as a world payment currency, and is the world's sixth most traded foreign exchange currency. We expect it to soon overtake the yen, one of the four components of the SDR, as a world payment currency.
This alone could be enough to warrant the currency's inclusion in the SDR, in our view. Another criterion for inclusion, however, is "full convertibility," which the currency has yet to achieve.
Progress here depends on the liberalization of China's capital account, the impetus for which is building rapidly, as shown by the growth in the country's various cross-border investment schemes. In a dramatic development last month, China announced that central banks, sovereign wealth funds and supernational organizations can now access the Chinese bond markets directly and without quotas - effectively a full opening-up of the capital account.
As part of its push toward a more open economy, the country is restructuring its state-owned enterprise sector with a view to privatizing parts of it. It's also pushing local governments into refinancing their bank loans in the domestic bond market, creating a municipal bond market, which sprang to life this June with RMB¥734 billion of issuance.
For China, the end game is the country's inclusion in global investment indices. As with full currency convertibility, the country is not quite there yet, but is on its way: in May, index provider FTSE Russell began transitioning China A-Shares into its global benchmarks.
To achieve these policy goals, China needs to maintain a stable currency, and this alone is a strong argument against near-term volatility or depreciation, in our view. The currency's fundamentals make a similar point: despite a record trade surplus, the RMB's appreciation to date has captured only a fraction of the growth in China's massive near US$4 trillion of foreign exchange reserves.
The risk we see to our RMB outlook is that the currency could come under pressure if unemployment in China rises. China's labor market is notably resilient, however; its 4% unemployment rate has changed little over the past 10 years or so. Our analysis of current data suggests that employers are hanging on to employees because of the difficulty of replacing them. This would explain why wages have been trending higher.
On balance, while risks remain and more setbacks can be expected in China's long and arduous road to becoming a modern economy, the prospects for stability and long-term appreciation in the RMB remain sound, in our view.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Hayden Briscoe, Director of Asia-Pacific Fixed Income, joined AllianceBernstein in August 2009 and is responsible for the Asia-Pacific Fixed Income business and for managing global and regionally focused portfolios.