China – What’s at stake with the yuan

Macro Highlights - 16/02/2017

The decline in foreign exchange reserves and the rise in capital outflows are a reminder that Beijing can only support the yuan for so long. However, rapidly switching to a floating exchange-rate regime would cause widespread instability. In the short term, the Chinese government holds the currency reserves it needs to continue guiding the yuan. Beijing should favour higher interest rates and tighten capital controls.

Recent manufacturing PMI indicators, which declined slightly but continue to point to expansion, show that the stability of GDP growth trends in China is well entrenched. Investors are now focussing on statistics concerning the country’s foreign exchange reserves. China’s reserves fell another USD 12.3 billion in January, to USD 2.998 trillion, just below the symbolic level of USD 3 trillion. The decline in January was lower than in recent months, and this is most likely the result of stricter capital controls and positive valuation effects. But it still raises questions about the minimum amount of currency reserves that China needs to (i) maintain its net international investment position and (ii) support the yuan.

As to the first concern, China’s foreign exchange reserves appear to be sufficient, as they cover 220% of total external debt. The second point is less clear. There is no formal rule that sets the minimum level of currency reserves, but the International Monetary Fund's (IMF) recommendations serve as useful guidelines. They set a suitable level of reserves for a given country, taking into account its exchange-rate regime (which for China is fixed, or, to use the IMF’s terminology, a crawl-like arrangement) and the level of capital account openness (allegedly closed in China). Under this methodology, China's ratio is close to 165%, which is above the IMF’s recommendation of 100-150%. In other words, China should have at least USD 1.750 trillion in foreign exchange reserves. This means the government still has some room for manœuvre. 




In the longer term, however, China cannot afford to support its currency indefinitely. Declining currency reserves make investors wary of how much more the People’s Bank of China (PBoC) can do, and this in turn puts downward pressure on the yuan, forcing the PBoC to dig further into its reserves. It is a vicious cycle. For this reason, the speed at which China’s reserves are dropping is a cause for concern. If they fall too fast, the monetary authorities will have to take firmer action, and this will feed the market’s fears about the yuan. We can look to the net errors & omissions line of the country’s balance of payments for an estimate of how much capital is leaving China – often via indirect routes that bypass capital controls. Not only do these capital outflows show that the capital account is not completely closed, but that the outflows themselves have increased in recent quarters (see right-hand chart). If China's capital balance were open, the country would need a minimum of around USD 2.850 trillion in currency reserves according to the IMF's methodology – a figure that is not far from the current level. The minimum level of foreign exchange reserves needed in China is probably somewhere between these two figures (USD 1.750 trillion and USD 2.850 trillion). This means the Chinese authorities have a cushion, but it also shows that the current policy for managing the yuan cannot be maintained for much longer.

The Chinese government is probably going to step up its efforts in the area of capital controls. By reducing outflows, the government can hope to ease downward pressure on the yuan. Capital controls have indeed tightened in recent months: individuals and companies now have more paperwork to complete in order to conduct foreign currency transactions. In the long term, a more closed capital account is not a lasting solution. It would run counter to the country's internationalisation and deprive the country of the capital it needs to expand its economy. That said, in the medium term this option looks more reasonable than suddenly switching the yuan to a floating exchange-rate regime. Such a switchover would cause widespread instability by allowing massive capital outflows that would drive up refinancing costs in a debt-laden financial system. The upcoming political transition for Xi Jinping at the end of 2017 makes the latter option even more unlikely. Donald Trump could also use such a move to accuse China of being a currency manipulator.

In addition to tightening its capital controls, the Chinese government is likely to keep interest rates high. A number of market interest rates were recently raised, in part to clamp down on shadow bank lending, and the amount of liquidity injected into the financial system was reduced. These two moves should help reduce downward pressure on the yuan by narrowing the interest-rate spread with other regions, including the United States. Measures of this type should continue over the coming weeks. We would add that, early in the new year, many Chinese households have probably already exercised their right to convert the equivalent of USD 50,000 per year into foreign currencies. This effect should gradually peter out over the coming months. These factors point to a moderate depreciation by the yuan against the dollar: we forecast an exchange rate of 7.20 against the dollar at the end of 2017. The yuan could drop more sharply, however, if the Fed picks up the pace of its monetary tightening or if Donald Trump pursues a tough protectionist line against China. The repatriation of profits by US companies could also work against the yuan. The Chinese government’s real challenge lies in the structural reforms needed to transition the yuan to a floating exchange-rate regime without triggering massive capital outflows. We will come back to this point in the coming weeks.


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