Friday, 14 December 2018

Yuan problem after another

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China’s renminbi is close to winning its global colours as an IMF reserve currency – but recent market turbulence has not helped.

With the wisdom of the ancients, an old Chinese proverb suggests that prosperity and calamity are different sides of the same coin – an insight that captures well China’s current condition.

Just as it was standing confidently poised to convince the IMF that the renminbi should be included in its basket of global reserve currencies, chaos on the equity markets cast a shadow over Beijing’s global pretensions.

It is small wonder then that the IMF has extended until September 2016 its existing Special Drawing Rights basket of reserve currencies – the US dollar, euro, Japanese yen and pound sterling – offering China a window in which to tie up loose ends.

The Fund is likely to make a final decision on the renminbi’s inclusion in November, but deferring implementation until next year would enable it to time this to coincide with the Chinese presidency of the G20 while securing the support of US President Barack Obama in the dying days of his term.

If patience were a virtue, the government in Beijing might be considered one of the world’s most virtuous for refusing to abandon its ambition for SDR inclusion after the IMF snubbed the renminbi at its last five-yearly review of the basket in 2010.

But this patience merely reflects confidence that there has until recently been little doubt that the IMF will incorporate the Chinese currency. As managing director Christine Lagarde has stated unequivocally, it is not a matter of “if” but “when”.

Karine Hirn, head of East Capital’s Asia team based in Hong Kong, said: “They do this review only every fifth year and that’s a bit of an issue because it’s a bit too early today but at the same time it will be too late by 2020. If I would have to bet on it that would be my bet: they will consider that it is too early now but we don’t want to have to wait until 2020 so we might look into it again before that, outside of the regular schedule of the SDR review.”

According to the IMF, the world’s central banks had allocated more than US$6trn of foreign-exchange reserves by the end of last year, more than 60% in US dollars. But use of the renminbi as a reserve currency is growing and in June, Standard Chartered said CNY assets now accounted for US$70bn–$120bn (0.6%–1.0%) of global FX reserves.

Nonetheless, potholes have appeared along the path to SDR inclusion during a turbulent summer that will, inevitably, focus minds at the IMF.

On August 11, China surprised the world’s financial markets with a 1.9 percentage point cut to the daily fixing rate against which it allows the renminbi to trade against the dollar, and in just three days, the currency weakened by 3.8% to its lowest level since 2011.

Then, China’s equity markets plummeted, culminating on August 24 in the 8.5% plunge now known as “Black Monday” and triggering a global shares rout. In apparent response, the central bank (PBoC) cut the one-year lending rate by 25bp, bringing it down to 4.6%, reduced the savings rate, and lowered the reserve requirement ratio.

The Chinese government said it would close the gap between the fixing and market-based valuations of the renminbi and then let markets determine the FX going rate. While it is not allowing the renminbi to float freely, the regime it has adopted represents calculated intervention characterised by more flexibility.

The IMF has welcomed the PBoC’s new FX mechanism – closing the gap between the fixing and market-based valuations is a requirement for SDR inclusion.

“A significant portion of investors are trading on headline risk rather than actually knowing the facts”

But the moves were widely interpreted as a response to slowing growth – Chinese exports tumbled by 8.3% in July – an interpretation dismissed by Danny Tenengauzer, RBC’s head of emerging markets research and global FX strategy.

He said: “China is adjusting to different things. One, it is transitioning from an investment-led model to a consumer-led model, which basically means it will become less productive by definition. There is also an accounting correction going on because we all know for various reasons GDP has been somewhat overstated over the years.

“As a result we see numbers coming across that are weak: is China’s economy really collapsing? I don’t think so. There is a lot of misinformation in the market. A significant portion of investors are trading on headline risk rather than actually knowing the facts.”

Jan Dehn, head of research at Ashmore, also believes it is misguided to see China’s move as the opening salvo in a global currency war, and says it obeys the strategy to achieve SDR status.

“Unambiguously, this brings China closer to SDR inclusion,” he said. “This was one of the specific requirements of the IMF’s technical review of a few months ago, which highlighted the gap between the overnight fixing rate and the market rate. What China has done is to eliminate that gap by bringing the fix to where the currency is trading; so this is essentially ticking one of a few boxes required for formal SDR inclusion.”

Hirn of East Capital said the recent devaluations might have been small but in the final analysis represented a significant development for markets.

She said: “We were thinking that SDR inclusion implies stability but they decided to forgo this principle in order to introduce a market mechanism. A 3% or 4% weakening of the renminbi is not that much, but it is very significant in terms of the world macroeconomic environment because what China is doing is saying that the market will determine the FX rate. To me, this not a sign of weakness but of strength.”

Dehn of Ashmore believes Beijing’s thinking was also influenced by the problems that QE in the economies of the other SDR currencies are storing up for China.

He said: “China is taking a long-term view, saying, of course, QE is linked to inflation and inflation will lead to currency weakness – that means China will experience strong currency appreciation.

“China has got a lot of reforms to do in the next couple of years before this begins and during that reform process it is going to have economic weakness, so the last thing during this transition period that it actually needs is to be piggy-backing on a dollar that is basically moving into bubble territory because of QE flows.”

US reticence towards the renminbi’s inclusion in the SDR has been premised on the decades-long argument that it has been kept at an artificially low rate. Under pressure from Washington, Beijing has let the currency appreciate by about 30% since 2005.

In May, the IMF defied its biggest shareholder by declaring that China’s currency was no longer undervalued. However, the dollar has appreciated in the past year, dragging the renminbi higher – and hitting Chinese exports. Beijing has wisely concluded to float now.

However, the IMF might also be forgiven for asking broader questions about the way China’s authorities managed the recent equities crisis – and even about the country’s stability.

“China’s stock market gyrations this summer are obvious headline fodder, but in themselves remain marginal to the broader economic and political outlook. What does matter is the way in which official policy has failed to control the markets effectively”

Jonathan Fenby, managing director of China Research at Trusted Sources, said the turbulence in August posed a key question about the impact of recent events on the political leadership and whether the country was heading for a period of instability.

“China’s stock market gyrations this summer are obvious headline fodder, but in themselves remain marginal to the broader economic and political outlook,” he said. “What does matter is the way in which official policy has failed to control the markets effectively, as shown by the sharp decline on Black Monday, and the apparent belated decision of the authorities to let the market find its own level.

“This raises the question of competence and the broader political issue of how the public will perceive the leadership as the strains of slowing growth continue to be felt.”


On paper, China appears close to fulfilling the main criteria to join the SDR, which comprises currencies issued by the largest exporters that are “freely usable” on international markets.

On exports, there is no disagreement that the country ticks all the boxes – it now accounts for more than 11% of all world trade, according to Standard Chartered – but the extent to which the renminbi is “freely usable” remains under scrutiny. To meet this criterion it needs to be fully convertible, meaning a member country has to maintain its capital account open, allowing market forces to determine its price.

While the IMF does not explicitly require full convertibility and China has been liberalising frantically, many analysts believe too many capital account restrictions remain in place.

Chinese authorities have made a series of policy reforms to pave the way for full convertibility, but remain cautious about the risk of capital flight.

In June, investment bank AXA said presciently that the IMF decision would ultimately be political – coming down to how soon the currency would cross the finishing line with continuous liberalisation at the current pace.

Tenengauzer of RBC said: “This is clearly very subjective: What exactly is ‘freely available’?”

He said a key question would be the extent to which the markets where a currency trades – domestic stock and bond markets and the foreign exchange market – are “reasonably liquid and properly set up”.

Tenengauzer said China’s domestic bond market was reasonably liquid and traded on a daily basis but foreign investment still did not have access, and Chinese equities might have fulfilled this condition had the recent sell-off been less disorderly.

On the currency, efforts to keep the renminbi at 6.20 per dollar demonstrated that there was no real market, prompting authorities to switch their efforts to maintaining the spot level in a trading range close to the mid, around 6.38.

“But again it is still very heavily managed. There is no way a currency market is this well behaved,” said Tenengauzer.


Hold on to your hats


While it is too soon to predict the IMF’s final decision, it is clear that incorporating the renminbi within the SDR basket will have significant implications for global markets.

The sheer magnitude of Chinese exports are immediately likely to establish the renminbi as the third-highest weighted currency in the SDR: according to the IMF, the dollar has a 41.9% weighting in the basket, the euro 37.4%, the pound 11.3% and the yen 9.4%. The renminbi is likely to enter at between 13% and 14%.

This would confirm China’s ascent as a global economic power – and threaten the significant benefits the US has gained from the dollar’s reserve currency status.

Jan Dehn, head of research at Ashmore, said: “Having a global reserve currency essentially means you don’t have to accumulate reserves yourself because every time you trade with somebody else they already hold your currency.

“Everybody has dollars and is willing to trade in dollars, so the US doesn’t need any reserves and does not have to suppress its consumption in order to run trade surpluses to build reserves – that’s one of the big benefits of having a reserve currency. But China is going to be the pimp daddy economy of the world and what this essentially means is that the US is trying to delay that as much as possible because it erodes its very comfortable reserve status quasi-monopoly.”

SDR inclusion will also help accelerate the liberalisation of China’s heavily regulated financial markets, and lower transaction costs would stimulate the expansion of its companies overseas.

Reserve managers and institutional investors are likely to alter global investment allocations rapidly. In May, Standard Chartered and AXA said at least US$1trn of global reserves would switch into Chinese assets if the IMF endorsed the renminbi this year.

Danny Tenengauzer, RBC’s head of emerging markets research and global FX strategy, said: “Within a very short period of time you and I could be saying: ‘We already have in our portfolio euro-denominated instruments, dollar-denominated assets, sterling-denominated assets – we should also have renminbi-denominated assets.”

Moves to win SDR inclusion may already be having a knock-on effect upon existing portfolios. Dehn of Ashmore believes China’s adoption of a more flexible exchange rate increases risks to developed government bond markets, especially the US Treasury market, because it means China will need fewer FX reserves going forward. Reserves become less necessary for SDR currencies and so inclusion in the basket itself is also likely to reduce the share of US Treasuries within China’s overall reserve pool.

Dehn said: “As more and more Chinese trade and other financial transactions settle in renminbi there’s no need for China to have US$3.7trn of reserves, so within the next two or three years you could imagine US$1.8trn–$1.9trn of reserves becoming essentially investible resources that no longer need to be invested in US Treasury bills and other types of loss-making short-dated securities.”

He believes China could even use these assets to capitalise a new investment bank to dwarf its first foray into this area, the Asian Infrastructure Investment Bank launched this year.


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