The fallacies behind the RMB predictions

（中文摘要：踏入新一年，市場對人民幣未來走勢預測迥異。看淡的預期人民幣匯率將會大跌；樂觀人士則估計人民幣有機會動搖美元在全球的領導地位。可是這些預測並沒有經濟數據支持，甚至似乎是市場炒作多於實際分析。）

 

As we go into 2015, the market has various forecasts for the outlook of the Renminbi (RMB), ranging from a bearish view of a sharp decline in its exchange rate to a sanguine expectation of the RMB shaking up the US dollar’s global dominance. However, economic fundamentals and evidence do not support these assertions and suggest that these views were more hype than solid analysis.

 

Take the sharp RMB decline forecast as an example. The view that the USD105 billion decline in China’s foreign exchange reserves in the third quarter of 2014 reflected large capital outflows (and thus indicated an impending sharp fall in the RMB exchange rate) is wrong. The drop was largely due to China’s foreign exchange reserve valuation effect. Meanwhile, the argument that rapidly rising Chinese corporate debt would force a sharp drop in the RMB exchange rate shows a lack of understanding of, and ignores empirical evidence behind, China’s financial reality. It is also flawed to regard potential US rate hikes as a key factor affecting the RMB exchange rate. Let us examine these problems first.

 

Fundamental factors should still underpin the yuan’s mild appreciation trend in the medium-term, albeit with higher volatility. Acceleration in the opening of China’s capital account or a change in Beijing’s foreign exchange policy stance could change this trend, but this is unlikely to happen in the short-term.

 

Some daring analysts are forecasting a more than 8% decline in the RMB-USD exchange rate (to more than 6.6/USD from today’s 6.11) by the end of 2015. In contrast, I do not think the RMB’s fundamentals have changed sufficiently to warrant me changing my assessment of its mild appreciation outlook; I actually found that most of the bearish views were based on a distorted understanding of the currency.

 

If it were not for the People’s Bank of China’s (PBoC’s) intervention earlier this year, which forced a 3.4% devaluation of the RMB against the USD from its peak (to squash one-way bet on RMB appreciation), it would still be on track to appreciate by 1.5% YoY this year, as I had expected. Since the intervention, the RMB has appreciated by more than 2.0% (Chart 1). The medium-term fundamentals supporting the RMB’s underlying appreciation trend—in essence an external accounts surplus including a current account surplus and net inflow of long-term capital—remain positive (Chart 2). Notably, as I have foreseen and despite it being contrary to market expectations of a decline, China’s current account and net capital inflows have improved.

 

 

 

 

Many analysts have concluded that the USD105 billion drop in China’s foreign exchange (FX) reserves in the third quarter of 2014, the first decline since two years ago, was due to capital (including speculative) outflows. Some even argued that the drop reflected China’s move to sell its large holding of USD debt. However, there is no evidence to support such bearish views.

 

Firstly, allowing for exchange rate movements among the major currencies, China’s foreign exchange reserves might have remained unchanged in the third quarter of 2014. In other words, the valuation effect of the foreign exchange reserve portfolio could largely explain the USD105 billion decline. China’s central bank reports its foreign exchange reserves at face value and in US dollar terms. So even if it makes no changes to the foreign reserve portfolio composition, if the foreign exchange value of the non-USD portion falls, the headline value of the reserves will show a decline. This can be mis-interpreted as a change in the actual foreign exchange holding, effecting capital outflows and eventually putting downward pressure on the RMB.

 

Research by the International Monetary Fund shows that a large and growing share of China’s foreign exchange reserves has been allocated to non-USD currencies, notably the euro, Japanese yen and pound sterling, which together account for about one-third of the total. The currency weights provided by the IMF’s Currency Composition of Official Foreign Exchange Reserves database (or COFER) database gives a proxy for the composition of China’s FX reserves portfolio.

 

Although China does not report to the COFER database, most analysts assume that China invests its foreign exchange reserves in similar proportions to those reflected by the currency weights in the COFER database. In reality, China’s holding of European and Japanese assets may be larger than the shares indicated by the COFER data. The sharp depreciation of the euro, yen and pound sterling against the USD (by 8.5%, 8.3% and 5.2%, respectively) since the third quarter of 2014 has thus markedly reduced the value of China’s foreign exchange reserves, giving a false perception of large capital outflows.

 

Secondly, the US Treasury International Capital (TIC) survey shows that China’s holding of US securities in the first-half of 2014 actually rose, albeit by an only USD8 billion, a tiny portion relative to its USD1.8 trillion total holding. This imperfect measure of China’s holding of US assets should dispel the myth of China selling US securities as a reason for the recent decline in its FX reserves.

 

Granted, there have been hot money outflows from China in some months in 2014, but they have not been so large as to cause a sharp drop in the RMB, as some analysts have wrongly assumed.

 

 

RMB bears have also argued that record-breaking USD borrowings by Chinese companies would force a sharp depreciation in the currency sooner or later. Some have estimated that Chinese firms raised USD196 billion worth of debt in the first ten months of 2014, more than 11 times the USD17.7 billion raised in 2008. Others have estimated that China’s corporate debt swelled to 124% of GDP in the second quarter of 2014 from 110% in 2009, and that total dollar debt had risen to USD907 billion in June 2014 from less than USD390 billion before the US’s quantitative easing (QE) started.

 

I am not questioning the accuracy of these estimates since Chinese data is imperfect. But from both a practical and a theoretical basis, the argument that a sharp RMB decline can be blamed on these dollar-debt estimates seems flawed. For example, the estimated 907 billion total USD debt that Chinese companies are said to have raised since QE began in the US amounts to about 23% of China’s FX reserves. As compared to China’s USD4 trillion foreign reserve, which is 4.3 times more than this estimated debt, it is too small to have any material effects on the exchange rate.

 

Experience from previous currency crises shows that countries with total debt-to-exports of goods and services ratios of over 200% eventually hit a financial crisis point (a ratio of less than 100% is considered healthy, while 100%-200% is considered to be a critical range). China’s USD907 billion foreign corporate debt is equivalent to only 75% of its total goods and services exports. So it is not a concern for triggering a crisis that would crush the RMB exchange rate.

 

Empirical evidence also shows that when a country’s total interest payments-to-exports of goods and services ratio passes 20%, its debt becomes unsustainable, and financial/currency crisis will ensue; while a ratio below 10% suggests a sustainable debt burden and a ratio in the 10%-20% range is considered critical. Even if we assume an average—and very aggressive—10% interest rate on China’s USD debt, its interest-to-exports ratio would only be 8%.

 

The point is that the rapid increase in China’s corporate debt is indeed a concern, but it is not yet so grave that it would cause a sell-off of the RMB. China is a USD9.4 trillion economy, with total credit estimated at about 230% of GDP, or USD22 trillion. The estimated USD907 billion debt is about 4.2% of the total. This has two implications: 1) China’s debt is basically denominated in domestic currency, which (combined with its huge foreign exchange reserves with robust debt-servicing ability) reduces the odds both of a run on the RMB and of a debt crisis; 2) the rising USD debt exposure reinforces the need for a stable (or even a slightly appreciating) RMB exchange rate to lighten China’s debt repayment obligation.

 

 

So what would be the game changer to the RMB’s outlook? It is not the potential US interest rate hikes because the usual tools for analysing capital flows based on cross-country interest rate differentials do not apply to China. This rational analysis relies on the assumptions of free capital flows and high substitutability between Chinese and US assets, neither of which exist in China.

 

As long as China’s capital account remains closed and the RMB’s external balances remain overall in surplus, the RMB exchange rate will hold to its mild appreciation trend, albeit with rising volatility. The concerns about China’s rising foreign corporate borrowings need to be monitored, but they have been exaggerated by many sentiment-driven comments and erroneous concepts rather than being based on solid analysis.

 

The ultimate game changers to the RMB’s direction would be deterioration in China’s external balances to an overall deficit, a rapid opening up of China’s capital account or a change in the PBoC’s currency stance, or a combination of these drivers.

 

 

Now let us examine the sanguine view of the RMB displacing the USD as the global currency. The world is indeed not taking for granted the US dollar’s dominance in the global markets. Countries from China and Russia to Europe are questioning the dollar’s super reserve currency status. In a research report in August 2014, the European Central Bank stated that “The dollar’s dominance should not be taken for granted.”

 

Some global central banks are starting to diversify their reserves out of the dollar. Meanwhile, China has been building up momentum for internationalising the status of the RMB through foreign trade settlement, currency swap agreements and expansion of the offshore RMB market.

 

In just five years, the RMB has overtaken the euro to become the second most-used currency in trade finance (after the dollar) and the seventh most-widely used payment currency in the world, according to SWIFT. Beijing has assigned six offshore RMB clearing banks to Asian and European centres to expand the offshore RMB market. Thirty-three foreign central banks have signed RMB swap agreements with China worth more than RMB2.5 trillion in total.

 

The list of offshore RMB centres, clearing banks and central bank swap agreements will grow over time. And in September 2014, the British government announced its plans to become the first western government to issue an RMB-denominated sovereign bond.

 

Empirical research also shows that an RMB bloc is developing in Asia that could well displace the US dollar bloc in the region. Since 2008, the RMB has increasingly become an anchor currency in Asia with regional currencies tracking it more closely than the dollar and the euro. The RMB is also being studied by various official institutions for its role as an alternative asset held in the official reserves.

 

If China continues its structural reforms to liberalise its capital account, the RMB would likely become the third major reserve currency after the US dollar and the euro within a few years. This may come as a surprise, but it should not. Each of the current third-largest reserve currencies, the yen and sterling, accounts for only 4% of global central bank reserve allocation. Given its internationalisation momentum, the RMB could easily climb from less than 1% now to more than 4% in a few years.

 

 

All this has led some analysts to argue that the RMB might be heading towards unseating the US dollar as the primary global reserve currency. While the world may have lost confidence in some of America’s economic policies, the more relevant point is whether China’s policies command more confidence. This doubt underscores the inertia of the dollar’s global dominance.

 

The strength of the dollar in the wake of the subprime crisis, even though it was of the United States’ own making, has consolidated its safe-haven role. The depth and liquidity of the US Treasury market has made it the only major financial market to function smoothly during a financial crisis. The euro and the yen both have structural problems that limit their global role. The Swiss bond market is too small to accommodate central bank reserve flows, let alone the cross-border private sector and speculative flows.

 

So the dollar remains the only super reserve currency by default. And the strong internationalisation momentum of the RMB has to be put in perspectives also. At 42% and 30%, respectively, of total global payments, the dollar and the euro still lead the RMB’s 1.8% share by a huge margin (Chart 3).

 

 

So in the short-term, the RMB will erode but not displace the dollar’s leading global status simply because China suffers from a credibility problem behind its closed capital account. For China, the big question is whether it can use RMB internationalisation as a means to implement deep structural reforms to resolve its credibility problem. For the world, the RMB’s continuing ascent will cause volatility in the global monetary order, but it will inevitably have to incorporate the RMB as a major currency in the future.