RMB Interventions Paving Way For Reforms

| About: iShares China (FXI)

By Dan Steinbock

Recently, Chinese renminbi has depreciated substantially. In the short term, interventions will prevail; in the longer term, the currency will stabilize.
In the past quarter, Chinese renminbi (RMB) decreased by 4%, which is significantly faster than anticipated, due to rising tensions in foreign-exchange markets over China's rising debt and bubbling property markets. China has managed to stabilize growth, but not without capital controls, hefty lending and decisive interventions.

Recently, the RMB soared against the US dollar. By encouraging Chinese banks to withhold funds from other banks, the People's Bank of China (PBoC) tightened liquidity in Hong Kong, which led the overnight lending market to surge from 17% to 61% in 2 days - which, in turn, caused the RMB to soar in offshore market.

Due to efforts to stabilize the currency, China's foreign-exchange reserves fell to $3 trillion last month; the lowest since spring 2011. In the past 17 months, PBOC actions have penalized the reserves by $1 trillion.

The Trump-Fed challenge

Three years ago, the RMB was still close to 6.00 per US dollar. As Chinese growth decelerated, debt-taking continued and the Fed's rate hikes began, RMB weakened to 6.95 in 2016. As it recently got close to 7.00 per dollar, the PBOC moved to support the currency.

As Chinese companies and investors have tried to reduce their RMB stakes and diversify risk, the exchange rate has faced further pressure, which has led authorities to ratchet up controls on Chinese companies and investors investing offshore. Thanks to these measures, China's growth has been stabilizing, but at cost.

During the global financial crisis, China's huge stimulus package boosted confidence, supported the infrastructure drive, and prevented global depression. But excessive liquidity led to speculation in equity and property markets. The current credit target of 13% remains twice the growth rate. China can no longer rely on credit-fueled growth.

Now Beijing must manage its rebalancing, while deleveraging huge local debt. In practice, that means balancing between RMB depreciation and actions to defend the currency. After January 20, Beijing must also respond to a dual challenge of escalating trade friction with the Trump administration and rate increases by the Fed.

Pro-market economists have urged PBoC to permit the RMB to weaken to an "equilibrium level" before Trump's inauguration. Otherwise, they argue, PBOC will exhaust reserves to boost the RMB, which will only contribute to destabilization and capital outflows.

Timing of reforms

However, the proposed reforms will contest the tacit guarantees on state-owned enterprises (SOEs) and state-owned banks, which will cause a fair amount of uneasiness and distress in the short- to medium-term.

Nevertheless, the reforms are necessary to achieve China's rebalancing, which is central government's explicit long-term economic objective, and to double GDP per capita by 2020, which is vital for long-term social stability. The real question is the timing of the reform implementation.
Currently, analysts expect the RMB to trade at close to 7.10 by the end of this quarter and closer to 7.35 at the year-end. By the same logic, RMB per dollar could exceed 7.50 by 2018 and 8.00 by 2019. These projections are predicated on economic trends, which downplay the impact of government interventions, however.

While the impending economic reforms have been designed by the 18th Central Committee in the past five years, they will be implemented by the new Committee, which will be elected in the fall and which will govern until the early 2020s. Since economic change will not be sustained without political consolidation, leadership transition is likely to precede reform implementation.
In a benign scenario, within 2-3 years, the property markets will be on a more solid footing, credit target is expected to be significantly lower and quality of growth substantially higher. That's when the landscape will be more favorable for reform implementation. Meanwhile, the authorities are likely to continue the balancing act between short-term interventions and long-term objectives. Ironically, RMB interventions are paving way for reforms.

Strong dollar - or elevated volatility
At the same time, the relationship between Chinese renminbi and US dollar is shifting. In the past, the markets used the volatility index (VIX) as the barometer for risk appetite and leverage. After the Great Recession, US dollar has replaced the VIX as the "new fear index." Indeed, the RMB is not just coping with a strong dollar but with elevated volatility induced by the US dollar. Consequently, the RMB challenges will intensify in the short term, but stabilize in the medium term. With the US dollar, the trends may be precisely the reverse.

Disclosure: None.

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