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China: How so many got the RMB wrong

Overview

At the beginning of this year, shorting the RMB became the favourite play of fund managers and traders. Yet, as of the beginning of April, the RMB is up over 1 per cent against the USD (see Chart 1 below) and funds that bet on a large devaluation have lost billions. How did they get it so wrong?

Chart 1: USD/CNY

Those expecting RMB devaluation made three big mistakes:

  • They misunderstood the nature of the capital outflows, causing them to overestimate the pace of outflows going forward
  • They underestimated the adequacy of China’s FX reserves to support the currency
  • They failed to consider the possibility that the Fed might take rate hikes off the table and hence lead to a weakening of the USD generally

This note looks at the assumptions underlying these mistakes and explains where and why the RMB bears went wrong.

Capital flight was not the key driver

China saw large-scale capital outflows in 2015: net outflows reached approximately US$870 billion. Many traders interpreted these outflows as capital flight and assumed that they would continue into 2016 and beyond, thus putting further downward pressure on the currency. But, as we detailed in our 19 February 2016 note The real anatomy of Chinese capital outflows, the majority of the recent outflows are attributable to Chinese corporates paying off foreign debt or trying to increase dollar holdings in response to a strengthening dollar/weakening RMB scenario.

This is important with respect to the currency because there is a finite amount of outflows that can take place as a part of these processes. At some point, foreign-denominated debt will be paid off (or successfully hedged). Likewise, exporters who held payments in dollars and delayed changing them into RMB cannot do so forever since they need RMB in order to finance their operations on the Mainland.

In short, these flows were responsible reactions of firms to a weaker RMB, but they were bound to come to an end and did not constitute capital flight. Capital outflows slowed considerably in February and March, in part because at this point much of the foreign currency debt had been paid off or hedged and the decline in the dollar significantly decreased the incentive for firms to reduce dollar liabilities. Further, Chinese corporates are unable or unwilling to delay repatriating earnings from exports indefinitely so they must change dollars into RMB to provide the working capital with which to run their businesses.

The big danger for the currency comes from households. Personal deposits in China total more than Rmb58 trillion (US$9 trillion). If households decided en masse to exchange their RMB for dollars, then the RMB would come under considerable pressure. A hint of the extent to which household outflows could be destabilizing came in December and January, when households began converting their cash to USD on the advice of financial advisers. As a result, outflows in these two months spiked to record highs (see Chart 2 in Box 1 below).

However, these household outflows have slowed considerably since January, as the government has introduced tighter enforcement of capital controls. Every PRC citizen is entitled to exchange US$50,000 of FX annually. In the past, it was easy to circumvent this restriction, but our contacts in China say that this is no longer the case. The authorities have also clamped down on the underground banks that used to facilitate moving money out of the country. The result is that outflows have slowed considerably, down to roughly US$20 billion in March after being close to US$140 billion in December and January.

Box 1: Calculating outflows

Calculating outflows from China is more art than science because there is no agreement on what constitutes an outflow nor are there accurate data.

One quick and dirty way to estimate outflows is to subtract China’s trade balance from the change in official reserves, as this gives a rough estimate of the amount of money flowing out of the country outside of the current account. In China this method likely underestimates outflows as some capital outflows are disguised in the current account data and thus unaccounted for. However, it still gives an accurate picture of the trend. For our purposes, it is important to note that capital outflows hit record highs in December and January – as households became the key drivers – but slowed considerably in February, when enforcement of capital controls became more stringent and by which time many households had already used up their annual FX quotas.

Chart 2 below shows that outflows in February and March were the lowest in nearly a year, implying that corporate outflows have slowed, too, as debt has been paid off and exporters have stopped growing their dollar holdings.

Chart 2: Capital outflows

For a more detailed discussion of how we calculate outflows, please see our 19 February 2016 note mentioned above.

Underestimating reserves

Central to the argument of those shorting the RMB was the idea that the Chinese authorities would not have the requisite firepower to defend the currency. According to this theory, attempts to protect the currency would result in a steady drawdown of the central bank’s FX reserves, eventually reaching a level that would be no longer adequate to protect the currency; in such an event, the PBoC would be forced to abandon its exchange rate regime and let the currency float, much like the Bank of England in 1992 or the Bank of Thailand in 1997. And much like the GBP in 1992 and the THB in 1997, the RMB would suffer a sharp devaluation.

Key to this line of thought was determining at what point the PBoC would be unable to defend the currency. China’s FX reserves have declined by nearly US$800 billion to US$3.21 trillion, down from US$3.99 trillion in June 2014. According to those who were betting against the RMB, this meant that China was already approaching a dangerously low level of reserves. Some said that anything below US$3 trillion would be unsustainable, with the most widely cited number for the danger level being US$2.7 trillion. Kyle Bass of Hayman Capital – the most vocal of those shorting the RMB – used this figure to justify his widely publicized position.

In our opinion, interpreting the danger level of reserves as US$2.7 trillion is an egregious error. This figure was arrived at by a misreading of a 2011 IMF paper (and its 2013 update) that developed a framework for determining reserve adequacy in emerging markets. According to the IMF’s methodology, an adequate level of reserves for an economy with a fixed currency and an open capital account would be equal to 30 per cent of short-term foreign debt plus 15 per cent of portfolio liabilities plus 10 per cent of M2 plus 10 per cent of exports. Using this equation, Bass and others arrived at US$2.7 trillion, as detailed in Table 1 below.

Table 1: Hayman Capital calculation of reserve adequacy in China

The above calculation makes a critical mistake by assuming that China’s capital account is open and its currency fixed. While not completely closed, China’s capital account has considerable restrictions and thus is far from open. At the same time, its currency is not completely fixed either. The government does intervene to determine the level of the currency but attempts to adjust its fixing rate in line with market pressures. The IMF does not give a methodology for a “mostly closed capital account, mostly fixed currency” economy such as China, but it does provide one for economies with closed capital accounts and a fixed currency. This is more applicable to China than the open/fixed methodology chosen by Bass and others. Using the more appropriate closed/fixed methodology immediately lowers China’s reserve adequacy level by US$1 trillion to US$1.68 trillion.

But even US$1.68 trillion is likely a gross overestimation of necessary reserves in the case of China. This is because there is considerable reason to question the applicability of using a percentage of M2 as an indicator of reserve adequacy. In the above-mentioned paper, the IMF itself questions the applicability of M2, saying “broad money (typically M2) is less firmly based as an indicator, and there is little orthodoxy either on whether to use it or at what ratio”.

M2 is particularly inapplicable in the case of China, in our view. According to the IMF, M2 is used “to represent the stock of liquid domestic assets that could be sold and transferred into foreign assets during a crisis”. But given the tight capital controls in China that we described above, M2 is not representative of the stock of assets that could be sold. The IMF paper even explicitly states that in countries – like China – that have capital controls, “the weight on M2 could be reduced (or even eliminated)”. If we were to eliminate M2 from calculations of reserve adequacy altogether, then that would take China’s necessary reserves down to around US$500 billion.

Whether the level for reserves adequacy is US$1.7 trillion or US$500 billion (and it may be even less), the Chinese authorities are very far from being anywhere close to the danger zone. This conclusion is further supported by the fact that the FX resources available to “China Inc” (i.e. official reserves plus the FX liquidity that the country’s SOEs could come up with if necessary) far exceeds the official reserves figure.

A weaker dollar means a stronger RMB

Another mistake that traders made was to overestimate dollar strength. As our Chief Economist Larry Brainard detailed clearly last month (see our 1 March 2016 EM Strategy Monthly), expectations of dollar appreciation are misguided for two reasons. First, the Fed has had to back off its tightening stance as the fragility of the US and global economies becomes more apparent. Rate hikes are likely off the table for the foreseeable future. Second, expectations of further Euro weakness were overblown given the limited ability of the ECB to further cut rates and the sizable current account surplus of the Eurozone. The result is that over the past two months, the dollar has weakened by nearly 5 percent against other currencies (see Chart 3 below), which has eased depreciation pressure on the RMB.

Chart 3: Dollar Index (DXY)
The future holds more controlled depreciation

Although speculators were wrong to anticipate a sudden devaluation, they were not wrong in noticing that the RMB is overvalued. Despite slowing dollar demand from corporates and tight capital controls, net capital flows are still negative. The government has no desire to protect an overvalued currency because such an approach is expensive and hampers its ability to implement monetary policy. But at the same time it is keen to preserve stability. For this reason, we believe the authorities will continue to use a “managed float” approach, gradually guiding the currency down towards the market level but allowing occasional volatility to inflict pain on speculators.

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