We’ve been saying for some time that China’s reforms will happen more quickly than most people expect, and that’s proving to be the case on a number of fronts, including internationalisation of the renminbi. News that the People’s Bank of China is aiming for full convertibility this year provides yet more support for our view that the currency will continue to appreciate steadily.
Pace of reforms quicken
Perhaps because we spend a lot of time on the ground in China, visiting senior officials and business leaders, we often develop views that are at variance with the market consensus. A consistent theme in this respect over the last two or three years has been our insistence that change as a result of the country’s reforms will happen faster than most people expect.
Even we have been taken aback, however, by two recent developments which show how quickly things are happening. At a conference in Beijing last month, Zhou Xizouchuan, Governor of the People’s Bank of China (PBC), revealed that the central bank was aiming for full convertibility of the renminbi (RMB) during 2015. We had assigned the project a two-to-three year time frame.
Also last month, Premier Li Keqiang gave approval for some regional authorities to convert bank loans into municipal bonds. While it’s not yet clear how the original debt providers will be affected in terms of the cash flows they receive, the loan-fordebt swap will to some extent free up bank balance sheets and help reduce systemic risk.
It will also grow the municipal bond market by US$300 billion virtually overnight—an important step in the development of China’s domestic capital markets.
Beijing sees need for RMB strength
he progress China makes with these and other reforms is critical to the success of the overriding policy objective of rebalancing the economy from an investment-driven growth model to one in which consumption plays a greater role than it has in the past. It requires a balancing act: slowing growth to reduce leverage, while keeping employment high enough to avoid social instability.
Critics of China’s policymaking tend to be divided as to whether they see growth or reform as more important. Many, for example, have called for a depreciation of the RMB in order to stimulate China’s export trade, or have warned that the currency will effectively devalue anyway as the US economic recovery causes the dollar to strengthen.
Our conviction that the RMB will remain stable in the short term and continue to appreciate in the medium to long term has strengthened recently, for two reasons.
One was a recent visit to Beijing, during which we met with senior finance officials and discussed China’s liquidity and foreign-exchange rate policies. The officials argued persuasively that there was no plan to devalue the RMB or widen its trading band with the US dollar (although we remain alert to the possibility of changes to the daily foreign-exchange rate fixing mechanism, and continue to monitor the situation). They pointed out that devaluation was unnecessary, given China’s continuing strong export performance, particularly in comparison to its regional and emerging-market peers. They also noted that the RMB’s appreciation in real effective exchange-rate terms had not undermined China’s export competitiveness.
In an indication of the issues that China’s policymakers weigh when making decisions, one official stressed that the implications of devaluation for the sake of growth were different for a large country like China than they would be for, say, a small export-led country like Singapore: if China were to devalue, other regional and emerging-market economies would come under pressure to devalue their currencies, too. The official added that there were also domestic reasons for a robust currency (the need to import components to allow China’s manufacturing industry to move up the value chain, and to deter capital outflows into stronger currencies) as well as the strategic objective of maintaining the RMB’s strength during the process of internationalisation.
Governor Zhou’s more recent comment on the timing of RMB internationalisation was entirely consistent with this view, and that’s the second reason we continue to expect the RMB to strengthen. Policymakers are targeting two near-term milestones: inclusion of the RMB in the International Monetary Fund’s Special Drawing Rights basket, and inclusion of China in global bond and equity market indices—for both of which a strengthening, or at least stable, currency would be a prerequisite.
From a practical perspective, how would full convertibility be implemented in such a short space of time? The offshore RMB, or CNH, has been working well for exporters, importers and investors for nearly four years and 20% of China’s global trade is settled in offshore RMB. If we had to hazard a guess as to what might be the next steps, China could announce overnight that the CNH is now fully fungible into the onshore currency (CNY), thus making the RMB fully convertible.
Policy risks remain
The risk to this outlook lies in the policy imperative of managing the slowdown in the economy while also keeping a floor under employment. If further stimulus becomes necessary, how likely is Beijing to choose devaluation over another cut in interest rates?
In our view, it’s very unlikely. While China has been easing monetary policy for the last year or so, we believe it has scope to cut interest rates further. This seems likelier than using the alternative easing mechanism, which would be another reduction in the banks’ reserve-requirement ratio (RRR). The RRR remains high by international standards, but policymakers are reluctant to lower it because such action normally leads to an increase in lending activity in which the funds are directed to unproductive areas of the economy, such as property (hence the current focus on targeted lending to particular industry sectors).
The scope for further rate cuts lies in the fact that the PBC’s one- and seven-day repurchase rates (the rate at which the central bank lends to commercial banks) have been rising. This may seem surprising, given the volume of liquidity that’s been flowing into the system from successive monthly record trade surpluses (Display 1).
Domestic RMB liquidity, however, has in fact become quite tight as a result of domestic investors seeking to take advantage of the rising US dollar. The trade has consisted of transfers between domestic accounts rather than capital outflows, as can be seen from the sharp rise in foreign-currency deposits since last year (Display 2). In light of this, policymakers would be even more reluctant to devalue the RMB, as this would simply result in more inflows to US dollar deposits and tighter onshore RMB liquidity.
Another reason that devaluation is unlikely is that China has never in its history varied the exchange rate for reasons of domestic policy. This is because the country is a net importer of commodities and a strong currency is to its advantage. As commodity prices continue to fall, a robust RMB will help the margins of domestic businesses to expand—a vital component in helping to underpin growth.
By Hayden Briscoe, Director—Asia Pacific Fixed Income, AllianceBerstein
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