Overall, we think uncertainty around pace and time window of RMB depreciation is still the biggest risk for global capital markets this year, which adds further volatility along with shocks from oil and the Fed. China’s capital outflow and FX reserve depletion will take at least another six to nine months to stabilize, when FX reserve is down to a level still adequate enough that we believe. Therefore the near term lift of RMB risk towards the end of 2016 and early 2017, would be a big positive to global capital markets.
What are recent messages from PBOC implying?
Market has noticed RMB has been surprisingly stable during the last two weeks of February. What would make that happen? Given a thought, towards the end of the Chinese New Year holiday on Feb 14th, China’s central bank PBOC governor Zhou Xiaochuan received an extensive interview with leading media Caixin Magazine, marking the first time after two unexpected RMB depreciation, the governor is communicating with the market directly. The communication is in a way effective, to stabilize market expectations, especially before the G20 meeting late February. And Governor Zhou communicated with the market a second time during the just adjourned G20 meeting in Shanghai.
What are the implications from his speeches? Governor has been consistent in expressing his views on RMB, capital flow and FX reserves, i.e. his overall stance on China’s capital account liberalization is still his major task within his tenure, and just the pace of capital account liberalization can be faster or slower given market conditions stable or volatile. This means PBOC is looking for stable market conditions to depreciate RMB further, and PBOC believes along with elevated measures of capital control, capital outflow and FX reserve further depletion will be mitigated.
As we discussed below , PBOC would most likely choose the gradual deprecation path in fear of wide spread market turmoil, but the unexpected indeed adds the greatest uncertainty to global markets this year, which we believe is the biggest risk out there, along with oil and Fed.
China’s FX reserve, where it stands now?
China’s FX reserve stood at US$3.23 trillion by end of January 2016, a depletion of US$762 billion since June 2014 peak (a 20% depletion of peak value), in 19 months; and a depletion of US$420 billion since July 2015 when China unexpectedly and sharply deprecated the RMB in August 2015 (a 12% depletion of July 2015 value), in 6 months. RMB depreciation undoubtedly accelerated the pace of China’s FX reserve depletion, and capital outflow.
How concerned are they? In terms of FX reserve, what is the composition of FX reserve? How liquid and usable? What is enough? When to moderate? In term of capital outflow, what is the composition? What are the driving forces of capital outflow? When to moderate? And what are recent messages from PBOC (Caixin interview and G20 meeting in Shanghai) telling us? We believe these are key set of concerns in investors’ minds, and they will be there longer than market expected.
China FX reserve, what is the composition?
In terms of currency denominated, China’s FX reserve is composed of US Treasury (39%), indirect USD assets holding through third parties (such as asset management companies, including the US treasury holding in Belgium account,7%), other USD assets (US equity, US corporate debt and other, 11%), US Agency debt (Fannie Mae and Freddie Mac, 5%), Euro denominated assets (20%), and other currencies denominated assets (mainly GBP, CHF, JPY, other G10 currencies, and very small amount of emerging market currencies, 18%).
China’s FX reserve in USD denominated assets is around 62%, in line with other emerging market countries around 62.5% of their reserves in USD assets. And 20% of China’s FX reserve is in EUR denominated assets, which is similar to emerging market countries’ average of their reserves in EUR assets at 21%. The question here is what is the dynamics in the change of the composition of FX reserves? And it will certainly affect the liquidity and usefulness of the reserves, and most likely towards the direction of rising proportion of illiquid assets rather, as most liquid asset tends to be sold easily first.
China FX reserve, how liquid and usable?
The key question in investor’s mind here is how liquid and usable of China’s FX reserve, i.e. at what level, FX reserves is not liquid anymore and can’t be used to counter capital outflow?
The most liquid assets in China’s FX reserve holding would be in developed market bonds. In terms of US treasuries, by end of January 2016, China’s US treasury holding is at US$1.246 (a 39% of China’s FX reserve). If we also put consideration of indirect US treasury holdings such as the account in Belgium, the estimates would be around US$0.23 trillion with the recent sell down. Hence China’s US treasury holding would be around US$1.48 trillion (46% of China’s FX reserve). As for other DM bonds, it totals around US$800bn (25% of China’s FX reserve). Therefore 61% of China’s FX reserve is in developed market bond, which is most liquid asset that China is holding in its FX reserve.
If we include US agency debt, developed market equity and corporate bond holdings, along with developed market bonds’ holdings, the liquid and usable portion of China’s FX reserve is around US$2.5 trillion (a 77% of FX reserve). This implies, if China’s FX reserve is down to US$0.7 trillion, it is not liquid anymore. However, this is just coming from pure calculation. Will this happen? We think the probability of reaching that level is zero.
There are debates out there asking, theoretically, how soon can these liquid assets in China’s FX reserves be sold? We tend to think there is no time limit or constraint on it, and if China wants to sell, the liquid assets can be cleared right away. Just that practically, China wouldn’t take that step certainly, as the consequences of strong market reactions might bring severe turmoil to the global capital markets, and under this kind of black swan scenario which global markets have never experienced before, market would take much longer than expected period to return to normal.
China FX reserve, what is enough?
With the accelerated declining pace of China’s FX reserve, market is worried about the FX reserve adequacy of China, at what level it is not enough. What is that mysterious threshold, and how soon we will reach there?
There are different ways in calculating FX reserve adequacy, and each have its flaws. Generally when thinking of reserve adequacy, we would relate to four major variables, i.e. exports, short-term external debt, broad money, and other portfolio liabilities. It is easy to understand why exports, short-term external debt, and other portfolio liabilities are considered, but why broad money as well? Broad money is included to capture the risk of capital flight, as many recent capital account crises have been accompanied by outflows of domestic residents’ deposits i.e. deposit flight.
Many calculations out there, and the estimated range of China’s FX reserve adequacy level would be around US$2.5 trillion ~ US$3 trillion (without capital control), and around US$1.6 trillion ~ US$ 2 trillion (with capital control).
If we look into the major variables in determining the FX reserve adequacy, exports are not worries, as China is still in current account surplus; short term debt is declining rather; deposit flight wouldn’t be an option, as stricter capital control is already levied, and can be even stricter.
Hence we believe China’s FX reserve has the room of sizing down half from current level to US$1.6 trillion to fulfill the FX reserve adequacy level, with elevated capital control measures. However, we don’t think China’s FX reserve will reach that low level before stabilizing. What that level would be then?
China FX reserve, at what level the depletion will moderate?
We think China’s FX reserve depletion will moderate, at similar pace when China’s capital outflow is starting to moderate. When that would happen near term? We think it will likely take another six to nine months for China’s FX reserve depletion to moderate. Given current depletion magnitude of around US$120bn monthly, China’s FX reserve to the maximum will be down to around US$ 2.25 trillion to US$ 2.5trillion. And this still meets FX reserve adequacy level.
On the other hand, if more capital control measures along with larger than expected RMB depreciation in the next six to nine months, we tend to think very likely, then China’s FX reserve level would surprise to the upside, and stabilize at a level close to US$2.8 trillion to US$ 3 trillion.
China capital outflow, what is the composition?
How China capital flow (inflow or outflow), i.e.non-FDI capital flow is calculated? Generally we are using changes in FX reserve minus trade surplus, minus net FDI, minus valuation effects, and minus interest earnings, we will roughly get the non-FDI capital flow for that month. Markets try to do little revisions on over-invoicing or services trade, but they are not big in a way to change the overall picture.
It is clearly shown that China is experiencing non FDI capital outflow 22 months in a row, and the magnitude is becoming bigger ever since last August when RMB unexpectedly depreciated, with an average of US$120 billion non FDI capital outflow from last August to this January. And this doubles the average of US$60 billion non FDI capital outflow from July 2014 to July 2015.
China capital outflow, what are the driving forces?
Data clearly tells especially in the past year, the negative change in FX reserves lead to non-FDI capital outflow. What are the driving forces then? We think there are two main reasons:
- Repaying foreign debt. Chinese corporates’ foreign debt is around US$1.1 trillion in early 2015. There hence has been huge unwinding pressure, where corporates sold RMB and bought USD to repay their foreign debt. This foreign debt has now been reduced to US$800 billion by end 2015. Clearly there has been around US$300 billion of non-FDI capital outflow in 2015.
- Hedging. Financial institutions, corporations, and individuals who have never thought that the RMB would depreciate, have to hedge the RMB depreciation risk ever since last August. Hence the demand to sell RMB and buy USD is also very strong. The hedge ratio has to rise from its previous level of 20-30%.
China capital outflow, at what level it will moderate?
As for repaying foreign debt, we believe that China non FDI capital outflow could stabilize when the number of repaying foreign debt reaches around US$400-500 billion, which implies halving the size of current level. It will take at least another six to nine months, given accelerated pace of outflow.
As for hedging, the situation may stabilize when it reaches around 50-60%, a rise from previous 20-30% level. And this may take similar amount of time around six to nine months as well, to reach that level.
In this due course, we continue to see FX reserve depletion, capital outflow and RMB depreciation. And if we focus on the movement in this following six to nine months, what are the likely trajectory, one off RMB depreciation to save FX reserves, and minimizing capital outflows; or at unexpected time windows, RMB gradually depreciated, hence FX reserve depletion and capital outflow extended. We tend to think gradualism in RMB depreciation would with high probability be the path chosen by PBOC, given unaffordable consequences caused by the prior two windows of RMB depreciation.