As China’s policy regarding continued intervention in its currency market increasingly appears to be reaching an inflection point, we have been closely following the data over the past months in order to ascertain whether there has been a change in this policy. The initial conclusions from the first few months of this year were that interventionist policies were continuing and that the recent weakening in the currency was largely policy-driven. Indeed, the US Treasury issued a statement warning China against renewed depreciation efforts (and carefully worded its claim to such in its recent exchange rate report). But Chinese officials have claimed that this depreciation has been market-driven. As we look at the first quarter, the data appears quite mixed. In today’s post, we attempt to parse the data and rhetoric to find a coherent explanation for what occurred in the first quarter.
To summarize, the first quarter of 2014 was one characterized by increasing uncertainty regarding the trajectory of China’s growth. Many economists have marked down their growth forecasts for this year following emerging troubles in the financial sector, overcapacity in the industrial sector, and political tensions surrounding the anti-corruption drive. These concerns, coupled with weakening hard data releases, have led some to believe that the recent downdraft in the renminbi starting in mid-February was market-driven, as several Chinese officials have claimed. When looking at the first quarter’s data, this claim seems at least questionable.
Tuesday, the US Treasury released the data for China’s holdings of US long-term Treasuries showing that they decreased slightly in February. At the same time, the transaction data from a separate Treasury report suggests China was a net purchaser of US Treasuries. As we have noted in previous posts, the transaction data is less reliable for estimating China’s holdings, but it is still informative, especially when the direction of change differs from the holdings survey. The differences between the two surveys, and indeed the change in February on balance, is small enough to be regarded as a neutral reading. Furthermore, the trade balance, while being positive for the whole quarter, declined in the February and remained weak in March. The February weakness was expected given the distortions created by the Lunar New Year celebrations and, while some analysts claim that it was still low after accounting for the holiday, it is close enough to previous observations to also be inconclusive. However, running counter to these data, the PBoC released the preliminary first quarter reserves data, showing that reserves increased by over $120 billion. The question is how this could be if the recent weakness was market-driven, and the trade balance had declined so much.
For this, we look to monthly estimates capital flows for what could have caused the increase in reserves. It is here that an interesting explanation begins to emerge. In January, the RMB faced appreciation pressures as it traded persistently towards the top of its official daily trading band. External appreciation expectations continued to increase, as evidenced by the premium that opened up between the offshore and the onshore rates (exihibit 1). Furthermore, incremental tightening of credit conditions in China caused the rate differential between the onshore benchmark rate and the offshore RMB as well as the dollar funding rates to persistently widen in the fourth quarter of 2013 until January this year, further encouraging this carry trade and the requisite capital flows. In February, facing remarkable capital inflows (exhibit 2), the PBoC decided to take action and stave off the speculative flows which were putting pressure on the currency, and this led to a decrease in the accumulation pressure (exhibit 3). This sharp policy-driven depreciation, coupled with the plausible increasing concerns about the financial and industrial sectors, likely then generated a legitimate cooling of investor sentiment on the RMB and eased, or even reversed, these capital flows.
Exhibit 1: CNY vs. the deviation from the official fixing rate and offshore premium
Source: Bloomberg, PBoC, author’s calculations
Exhibit 2: Estimate of China’s unaccounted-for capital flows vs. HSBC manufacturing PMI
Source: Bloomberg, PBoC, China National Bureau of Statistics, author’s calculations
Exhibit 3: Change in FX positioning by banks vs. change in FX reserves
Source: Bloomberg, author’s calculations
What to make of this data going forward? As our colleague Nicholas Lardy recently pointed out, China is likely experiencing a moderate slowdown in the pace of growth. If this is the case, and if this leads to a continued slowdown in the industrial sector, then appreciation pressure should, at least on the margin, decrease. This should lead to a slowdown or outright reversal of reserve accumulation. However, one result of China’s bifurcated capital markets is that even as the PBoC moves to tighten policy domestically, foreign capital flows (despite the tight controls that exist) move into the mainland into sectors such as real estate, exacerbating a distortion the policy was intended to remedy. While we believe (and noted in a previous post) that a greater role of the market in the determination of the currency would allow for a healthier two-way trade, it seems that as China’s leaders focus on rebalancing domestic growth with a mixture of structural reforms and targeted, moderate stimulus, strong policy changes – either towards further liberalization or even policy-driven depreciation – are unlikely.