Hayden Briscoe

Yesterday’s announcement that China will join the reserve currency basket of the International Monetary Fund is only one aspect of a process that could channel up to US$3 trillion ($4.2 trillion) into the country, global asset manager AllianceBernstein (AB) said yesterday.

While the development is beneficial for China in the long term, the management of such large flows could cause some short- and medium term challenges for Chinese financial authorities.

“Capital flows arising directly from this development will be relatively small in themselves, at around US$40 billion,” said Hayden Briscoe, AB’s Managing Director—Asia Pacific Fixed Income.

“But it’s a symbolically important development which enhances the prestige of the renminbi as an internationally traded currency. This should help underpin China’s continuing efforts to internationalise the currency and its capital account—moves which, our research suggests, could lead to inflows of up to US$3 trillion over the next few years.

“This represents a significant portfolio rebalancing for global bond and equities investors which will have far-reaching effects on China’s capital markets and economy, as well as financial markets and currencies elsewhere.”

The International Monetary Fund announced in Washington overnight that, from October 1, 2016, the renminbi would be included in its Special Drawing Rights basket, together with the US dollar, euro, Japanese yen and British pound.

The SDR is an international reserve asset created by the IMF to supplement its member countries’ official reserves. The renminbi will comprise 10.92% of the SDR, placing it third behind the US dollar and euro (41.73% and 30.93% respectively) and ahead of the yen and pound (8.33% and 8.09%).

“A key question for investors in the short term is, ‘How will the country cope with these expected inflows?’” said Briscoe.

“We expect that, in part, the response will be for the People’s Bank of China to focus on managing the currency, as a stable exchange rate will be a key factor in maintaining some balance between capital inflows and outflows.”

The post China to ‘focus on currency stability’ in face of inflows of up to US$3 trillion appeared first on AdviserVoice.

There are signs, though only tentative, that the global investment and policy landscape in fourth-quarter 2015 could lead to a reversal of what, three years ago, were three key market-shaping events.

Then, markets were in an expanding “balance sheet world”, in which central banks were pumping more liquidity into the global financial system to keep economies afloat.

In September 2012, the US Federal Reserve launched its third round of quantitative easing (QE); in December that year, Shinzo Abe became a second-time Prime Minister of Japan and, two months later, launched his Abenomics reforms in an attempt to boost the country’s growth and inflation.

The central banks hoped that, by helping to lift asset prices, they would reignite the “animal spirits” in their economies. An important consequence of these actions was that financial markets—particularly risk assets—became dislocated from the macro environment, as liquidity drove valuations higher than economic fundamentals warranted.

Display 1 shows asset price cycles (expressed as the ratio of household net worth to income) have become more dominant in the business cycle during the last two decades or so, at times of increased balance sheet leverage in various sectors. The most recent spike, beginning in 2012, coincides with the leveraging up of central-bank balance sheets.

In Japan, equities have enjoyed a sustained rally until recently, beginning around the time that Abenomics was introduced in 2013 (Display 2).

At the same time, there was a counter-current to these events. In November 2012, Xi Jinping became President of China and—as part of a suite of reforms aimed at rebalancing the country’s economy—launched a crackdown on corruption.

As the US and Japan attempted to stimulate growth, Xi’s actions had a dampening effect, leading to a slowdown in infrastructure and other projects in China. This in turn effectively put an end to the global commodities boom and created economic headwinds for commodity-exporting countries.

All change

In October 2015, each of these three policy initiatives appears to be doing a U-turn. Having put an end to quantitative easing a year ago, the Fed—though weighing an improved US economy against global market volatility—is expected soon to raise short-term interest rates for the first time in nine years.

The policy debate in Japan now revolves around whether or not the Bank of Japan (BoJ) should ease further, with the BoJ governor arguing against it on the grounds that the country is through the worst of its deflationary spiral. If he’s right, we believe Japan could signal a tapering in its QE program next year. This is an out-of-consensus view as the market is still looking for an extension or top-up of the programme.

We expect China’s 13th Five-Year Plan, to be announced after the October Communist Party plenum, to focus on reforms that will continue to push the economy up the value chain, making it more efficient and innovative, with the aim of reducing the risk of the country falling into the middle-income trap.

We’re encouraged in this view by Xi’s recent engagement with the international community, including a state visit to the US in September and, more recently, the UK, with bilateral trade agreements high on his agenda. Premier Li Keqiang has been similarly active across Europe.

China, in other words, still seems to be moving in the opposite direction to that of the other countries in terms of policy—this time, however, it’s more pro-growth, while the US and Japan contemplate moving to tighter policy settings.

Macro factors back in play

Together, these trends point to a rebalancing in global markets during 2016. With the US poised to raise interest rates, Japan potentially tapering its QE and China experiencing a mild cyclical upswing, macroeconomic factors are likely to reassert themselves as key investment drivers, in our view.

For the riskiest assets which have been decoupled from fundamentals, this can only mean a reversion of valuations to more normal levels.

Silver lining in China’s clouds

While it may be too soon to rely on these straws in the policy wind as presaging a change in the global investment landscape next year, we see some fundamental trends— especially in China—which appear to support the case that such a change may occur.

This may seem unlikely, given that headlines about China’s economic growth continue to be overwhelmingly negative. The fact that the decline in China’s heavy industry sector is hurting western companies with significant exposure in that area is not to be taken lightly.

In our view, however, the headlines tend to overlook or underrate the key fact that the composition of China’s GDP growth has changed, as shown by Display 3.

The contribution of the secondary sector or industry— traditionally the main driver of growth—has declined as a share of GDP, while the tertiary (services) sector has boomed, to the point that it now accounts for 50% of GDP.

This is fully consistent with China’s goal of rebalancing its economy in order to avoid the middle-income trap, and counts as a major policy achievement. It’s good news for investors, because it points to more sustainable, if lower, GDP growth over the long term.

As Display 4, next page, suggests, year-on-year growth in services is buoyant, while the industry sector remains in a steep decline. That said, we detect some silver linings in the clouds hanging over China’s non-services sector.

Display 5 shows how growth in the infrastructure and housing sectors peaked during the commodity boom and how they have fared since President Xi came to power in 2012. Infrastructure has stabilised, while housing and manufacturing have continued to decline.

While we don’t see any turnaround in manufacturing in the short- to medium-term, we are more positive on infrastructure and housing. In the case of infrastructure, we expect the new Five-Year Plan at the very least to maintain investment at current levels and, possibly, to increase it.

There is any case a great deal of liquidity waiting to be invested in infrastructure—a result of the exponential growth in the municipal bond market, created earlier this year after the central government forced local and provincial governments to reduce their reliance on bank finance.

Current outstandings are RMB3.7 trillion (US$580 billion).

In housing, we see the possibility of a cyclical upswing, possibly by the middle of next year. Display 6 indicates that supply (as represented by Floor Space Started) and demand (Floor Space Sold) are now in balance, and that excess supply is diminishing steadily.

Our research shows that house prices in Tier 1 and Tier 2 cities have begun to rise, and that the trend is spilling over into Tier 3 cities.

If these trends continue into next year, we expect them to trigger a revival in property development. This will surprise the market, which has interpreted the downturn in the sector as the bursting of a bubble, rather than a cyclical change.

A revival in property development would also be supportive for the broader economy, in our view, and positive for the global commodities market—although we’re not suggesting that demand for commodities will return to anything like pre-2012 levels in the foreseeable future.

By Hayden Briscoe, Director, Asia Pacific Fixed Income, AB

———

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material, or an offer or solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. References to specific securities are provided solely in the context of the analysis presented and are not to be considered recommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors and companies described herein. This document is not an advertisement and is not intended for public use or additional distribution. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

The post Will the global investment landscape realign in 2016? appeared first on AdviserVoice.

Two are particularly interesting, in our view: the growth of the domestic corporate bond market and signs of improving fundamentals in the property sector. While driven by different dynamics, the trends are potentially mutually reinforcing, with encouraging implications for the broader economy.

One of the key drivers of change is government policy, the overall thrust of which is to ensure that China avoids falling into the middle-income trap. The strategy is to rebalance the economy so that domestic consumption plays a greater role alongside the traditional growth engines of investment and heavy industry.

This requires a range of reforms to stimulate private investment (foreign and domestic) and more efficient pricing of capital, and the liberalization of capital markets is a key step in the process. Hence policy accounts for much of the recent growth in the corporate bond market (and, as we discuss later, the municipal bond market, too). These developments have broad implications, as a bond market can help fuel economic growth and, from a balance-sheet risk-management perspective, lead to a more efficient matching of assets and liabilities.

One of the interesting aspects of the bond market’s growth is the extent of participation by property developers which, until relatively recently, were obliged to borrow offshore and repatriate the proceeds for investment onshore. Since the law changed a dramatic transformation has taken place, as captured by Wind Information, a financial data services company based in Shanghai. According to Wind, onshore corporate debt issuance in China totalled RMB232 billion (US$36.5 billion) in August. Property developers accounted for nearly 45% of the total.

It’s also worth noting that, of the 55 developers that have issued in the onshore market, only one is rated AA- by onshore agencies while the others are all rated AA or higher. The market is also becoming better at evaluating risk, with a number of issuers with the same rating being priced differently, based on fundamentals.

Not so long ago, the property sector was a major concern for investors and regulators. That concern has eased since it’s become evident that developers can diversify their funding sources and reduce their borrowing costs by issuing in the bond market. This benign trend is likely to continue, with bond market participants expecting issuance to grow for the rest of the year.

Property sales pick up

The trend is coinciding with improvement in the property market. National Bureau of Statistics figures for August showed that sales across the board increased by 15.3% year-on-year by value, with residential property continuing to outperform non-residential. Evidently the stock market correction in June and July and the currency devaluation in August have not dampened interest among property buyers. At the same time, however, real-estate investment and land purchases have fallen further (Display).

While there is further to go in the cycle before developers start to deplete their land banks, excess land stocks will be more of a problem in the lower-tier cities: in Tier 1 and Tier 2 cities, we see signs that a recovery is already under way and that developers are starting to worry about the availability of land.

Although this points to an eventual recovery in supply-side activity, we don’t expect such a change to become apparent before the second quarter of next year. The period between now and then, and the availability of funds from the bond market, could prove restorative for the property sector, giving developers time to stabilise their margins and improve earnings while maintaining healthy balance sheets.

China risk is conservatively priced

The benign coincidence between these bond-market and property-sector trends are further evidence in our view that China’s reforms, in some areas at least, are starting to synch with economic fundamentals, to the advantage of both.

Another example is the potential for a recovery in infrastructure activity. Earlier this year, the central government introduced a budgetary law which forced provincial and municipal governments to reduce their dependence on bank finance and raise capital in the domestic bond market. This gave rise to the municipal bond sector which raised RMB1.7 trillion (US$267 billion) in its first three months of operation.

We expect, once the central government announces its 13th Five-Year Plan next month, that this pool of liquidity will be channelled into infrastructure and other activities which will provide a boost to the economy late this year and well into 2016.

There are other upsides to the development of the municipal market: it’s lowered systemic risk in two ways, by removing the concentration risk of local-government exposure from the banking system, and by enabling local governments to lengthen the term of their borrowings. It also puts their debt into a form that can be purchased by institutions, thus creating better risk-sharing opportunities outside the banking sector.

In light of this, the warnings in recent media and sell-side broker reports about the increasing downside risks to China’s economy—and the consequent negative implications for the global outlook—seem misplaced.

Instead, we expect that, by the middle of next year, China’s growth may well have steadied and formed enough of a base for a rebound. That, in turn, suggests that the current pricing of risk in China’s markets is far too conservative.

By Hayden Briscoe, Director, Asia Pacific Fixed Income and Jenny Zeng, Research Analyst, Corporate Credit, AB

———-

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material, or an offer or solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. References to specific securities are provided solely in the context of the analysis presented and are not to be considered recommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors and companies described herein. This document is not an advertisement and is not intended for public use or additional distribution. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. References to specific securities are presented to illustrate the application of our research and investment philosophy only and are not to be considered recommendations by AB. The specific securities identified and described in this presentation do not represent all of the securities purchased, sold or recommended. Past performance is not a guide to future performance. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

The post China’s policies and fundamentals converge appeared first on AdviserVoice.

Hayden Briscoe

China’s decision earlier this month to change the way in which the central parity or “fix” rate of the renminbi (RMB) is determined has been widely characterised as a devaluation designed to shore up the country’s export trade. We question this assessment, for a number of reasons.

In our view, the move is much better understood in the context of China’s continuing efforts to deleverage and reform its economy, while avoiding a hard economic landing. As a competitive devaluation, it seems to make little sense from either a structural or cyclical perspective.

By a structural perspective, we mean the changes in the policy environment related to the reform process. A key reform, of course, is the internationalisation of the RMB, as a prerequisite to the opening-up of China’s capital markets.

China has made great strides in this respect in the commercial arena: in the last five years or so, the offshore RMB (known as CNH and traded in Hong Kong) has become the settlement currency for nearly 20% of the country’s trade (Display 1).

The currency has yet to make the same impact in the financial sector, but this is about to change. In a little-publicised move in July, China opened its capital markets to central banks, supranationals and sovereign wealth funds—a highly significant first step in the liberalisation of its capital account.

Given that these policies are aimed at increasing global usage of the RMB—and potentially elevating it to the status of a reserve currency— it seems strange that China would choose such a moment to “devalue” and risk losing the confidence of global investors.

Devaluation would hurt, not help…

From a cyclical perspective, devaluation seems to be unnecessary. For example, while China’s exports slumped 8.3% year-on-year in July compared with a 2.8% rise in June, the drop was less severe than the double-digit contraction experienced by the country’s regional peers.

The drop did little harm to China’s balance of payments because imports are falling even more quickly than exports, leaving the country’s trade in a net positive position.

The fall in imports is attributable both to lower Chinese demand for commodities (a result of another reform, the normalisation of the infrastructure programme) and to the associated fall in commodity prices. China, as a net importer of commodities, benefits from this.

That, from our point of view, is another reason not to devalue. For years during the commodity boom, the upward surge in prices was a headwind to China’s growth. Falling prices are a boost to the margins of Chinese commodity importers, and devaluation would reduce this advantage.

Falling imports also feed the country’s record trade surplus (Display 2) which has become something of an embarrassment to China in its political relationships with its trading partners. A deliberate devaluation of the currency would only exacerbate this problem.

… And would be politically embarrassing

It would do so at a bad time, too, as President Xi Jinping is due to meet President Barrack Obama in the US next month to discuss bilateral trade. For years, the US Senate has complained that China has kept the currency artificially undervalued. To devalue now, just a few weeks before the meeting, would look politically inept at the very least.

The Chinese president has another reason for keeping on the good side of his US counterpart: China wants the RMB to be included in the Special Drawing Rights (SDR) basket of the International Monetary Fund, and President Obama’s goodwill could be helpful in that respect.

In light of these considerations, we believe that the best explanation for the adjustment in the central parity rate was the one given by the People’s Bank of China: that it was intended to close the unusually wide gap that had opened between the fix and the spot price—in other words, to bring the RMB’s valuation more in line with that of the market.

A more market-oriented currency is, of course, essential to China achieving its broad policy objective of modernising the economy and opening it to foreign and domestic private investment.

Other aids to growth

While we don’t expect the currency adjustment to make any difference to exports, our analysis suggests that China’s policy measures will have a positive incremental effect on the currency and the economy in the next few months.

The opening of the capital account to central banks, supranationals and sovereign wealth funds will benefit China’s capital inflows, in our view. Between them, these institutions are estimated to control US$20 trillion to US$30 trillion. Even if the allocations they made to China were relatively small in percentage terms, they could have a profound effect.

Supranationals in particular are key users of the SDR currency basket, and so their involvement in RMB flows is likely to increase once the currency joins the basket.

Earlier this year the central government introduced a budgetary law which forced provincial and municipal governments to reduce their dependence on bank finance and raise capital in the domestic bond market. This gave rise to the municipal bond market where issuance, since inception three months ago, has reached about RMB1.70 trillion (US$270 billion).

We expect that, once the central government announces its 13th Five-Year Plan in October, this pool of liquidity will be channelled into infrastructure and other activities which will provide a boost to the economy late this year and into 2016.

The big picture matters

One conclusion we draw from the above is that it’s as important now as it’s ever been to look at the big picture when trying to understand what’s happening in China. As one stands back from the daily machinations of the markets, it seems strange that the world has been pressing China to accelerate its embrace of a more capitalist economic model, only to reel in anxiety and confusion as the country struggles with the reality of the challenge.

A likely consequence, in our view, is that investors and financial analysts will grasp the importance of incorporating into their China research a deeper understanding of the country’s internal politics, macroeconomic cycles, cultural differences with the West and—perhaps most importantly of all—its potential impact on global capital markets.

By Hayden Briscoe, Director—Asia Pacific Fixed Income

———–

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material, or an offer or solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. References to specific securities are provided solely in the context of the analysis presented and are not to be considered recommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors and companies described herein. This document is not an advertisement and is not intended for public use or additional distribution. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post China: What’s really behind the currency move? appeared first on AdviserVoice.

In the aftermath of China’s A-Shares correction, many investors may be more concerned about the potential for further instability in the country’s financial markets than mindful of areas of relative calm. One such oasis is the bond market, which behaved as bond markets are supposed to do in an equities sell-off, providing a safe haven for investors who suddenly became risk-averse.

Another is the currency market. Both the offshore (CNH) and onshore (CNY) renminbi remained essentially flat relative to the US dollar, with the Daily Fix being kept stable, indicating that policy makers wanted to keep the currency steady.

A number of investors we spoke to before the correction were sceptical as to how long the RMB could stay the course, given China’s slowing growth and multiple policy challenges. That scepticism has only intensified since the market pullback, amid broader doubts about how effectively China is pursuing its goal of becoming a more open, market-oriented economy.

We think such concerns are understandable, but that they need to be kept in perspective.

SDR is a sideshow

One example of what we regard as a distorted perspective is the extent to which the market correction and the government’s attempts to bring it under control are, somehow, seen as evidence that China’s economic and financial reform programme is in danger of being derailed.

According to at least one commentator, the government’s efforts to stabilise the market raised questions as to whether it would allow the RMB, once the currency reached full convertibility, to trade freely during times of market volatility.

Another currency-related example of distorted perspective, in our view, is the tendency to see the eventual inclusion of the RMB in the Special Drawing Rights (SDR) basket of the International Monetary Fund (IMF) as a measure of the currency’s progress towards full internationalisation.

For some time now, the IMF has been saying that the currency’s inclusion in the basket is a matter of when, not if. The basket is reviewed every five years with the next review due later this year and a decision expected in November.

Expectations until recently were strong that the RMB would be admitted to the SDR at that point.

Since the market correction, however, those expectations have evaporated, largely on the assumption that the IMF will want to wait until clarity has returned to the outlook for China’s markets and reform programme before taking further action.

As it happens, we agree that the RMB is unlikely to be included in the SDR this November; in our view, however, the reasons have nothing to do with impressions created by the share market correction and everything to do with high-level international politics.

During September, China’s President Xi Jinping will visit the US for talks with President Barack Obama on a range of topics, including bilateral trade agreements. This is a particularly important issue for China, which has not been included in the Trans-Pacific Partnership trade agreement being negotiated between the US and several Pacific Rim countries[1] .

Given the degree of influence that the US and its allies have within the IMF, we believe it’s likely that the RMB’s inclusion in the SDR basket will be held over until next year, or at least until after the US-China talks reach an outcome that both sides can support.

The symbolism of this would be useful both to the US, allowing it to be seen as having a degree of leverage over China (the implication being that SDR inclusion lies within its gift), and to China (by giving the RMB implicit US endorsement in the eyes of the rest of the world).

Incidentally, the value of RMB inclusion in the SDR is largely symbolic anyway, in our view, and attempts to present it otherwise (by suggesting that a delayed inclusion reflects negatively on the IMF’s view of China, for example) are another instance of what we regard as a distorted perspective.

China eyes the endgame

Our own perspective on the RMB is shaped by its fundamentals and our conviction that China’s reform programme—which we always expected would be buffeted in the short-to-medium term by setbacks such as market corrections and corporate defaults—remains on track for the long term.

The progress that the government has made in internationalising the currency, for example, illustrates the consistency in China’s policy thinking and implementation. The SDR issue has some relevance here: in 2010, the IMF considered but rejected the RMB for inclusion on the grounds that the currency wasn’t traded widely enough.

Today, partly as a result of the government’s vigorous promotional efforts, the RMB has become the second most used currency for documentary credit transactions (such as letters of credit), ranks fifth as a world payment currency and is the world’s sixth foreign exchange currency. We expect it soon to overtake the Japanese yen, one of the four components of the SDR, as a world payment currency (Display 1).

This alone could be enough to warrant the currency’s inclusion in the SDR, in our view (and it’s worth noting that, in May, the IMF said that the RMB was no longer undervalued—a clear signal that the organisation was favourably disposed towards the currency’s inclusion in the SDR).

Another criterion for inclusion, however, is “full convertibility”, which the currency has yet to achieve. Progress here depends on the liberalisation of China’s capital account—a process the government has escalated. In February, for example, capital account restrictions were removed for companies and banks in the Shanghai free-trade zone, freeing them to raise funds offshore, and the People’s Bank of China has indicated that full liberalisation could occur this year.

The impetus for liberalisation is building rapidly, as indicated by the growth in two-way cross-border investment encouraged by the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor programmes, the Qualified Domestic Institutional Investor schemes and Shanghai-Hong Kong Stock Connect—a system for trading between the onshore and offshore exchanges (soon to be followed by a system linking the Shenzhen and Hong Kong exchanges).

While these programmes are still subject to investment quotas, the quotas are constantly being increased and in time will be removed entirely. Indeed, in a dramatic development this month China announced that central banks, sovereign wealth funds and supranational organisations could now access the Chinese bond markets directly and without quotas—effectively fully opening up the capital account.

Not only is access to markets being improved, new investment opportunities are being created. As part of its push towards a more open economy, China is restructuring its state-owned enterprise (SOE) sector with a view to privatising parts of it. It’s also pushing local governments into refinancing their bank loans in the domestic bond market.

One effect of this is to reduce banks’ exposure to local governments, and so reduce systemic risk; another is to create a new municipal bond market. This sprang to life in June this year with RMB734 billion of issuance and is expected to be capitalised at around RMB6 trillion by the end of next year.

For China, the end game of capital account liberalisation is the country’s full inclusion in global investment indices. As with full currency convertibility, the country is not quite there yet, but is on its way: in May this year, for example, index provider FTSE Russell began transitioning China A-Shares into its global benchmarks.

Monitoring unemployment

To achieve these policy goals, China self-evidently needs to maintain some stability in the currency, and this alone is a strong argument against near-term volatility or depreciation, in our view. The currency’s fundamentals make a similar point: despite a record trade surplus (Display 2), the RMB’s appreciation to date has captured only a fraction of the growth in China’s massive near US$4 trillion of foreign exchange reserves (Display 3).

Our frequent conversations with policymakers in Beijing provide further grounds for regarding the RMB as riding at anchor in a sea of stability. The impression we have formed during recent discussions is that currency depreciation is unnecessary, given that China’s exports continue to perform well on a relative basis; it would also be self-defeating, as the effect would be to export deflation across the world which, in turn, would ultimately undermine China’s exports trade.

Also, as a net importer of commodities, China clearly benefits from the near-term stability and longer-term appreciation of the currency.

The one risk we see to our RMB outlook is that the currency could come under pressure if unemployment in China were to rise. This is something we would monitor carefully, particularly as restructuring of the SOE sector gets underway. To date, however, it’s worth nothing just how resilient China’s labour market appears to be: despite the steady slowdown in growth in recent years, unemployment has remained stable at around 4%.

On balance, while risks remain and more setbacks can be expected in China’s long and arduous road to becoming a modern economy, the prospects for stability and long-term appreciation in the RMB remain sound, in our view.

By Hayden Briscoe, Director, Asia Pacific Fixed Income, AB

[1] Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Singapore and Vietnam

———

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material, or an offer or solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. References to specific securities are provided solely in the context of the analysis presented and are not to be considered recommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors and companies described herein. This document is not an advertisement and is not intended for public use or additional distribution. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post Fundamentals and policy keep RMB riding at anchor appeared first on AdviserVoice.

“Global investors have been understandably transfixed by the recent gyrations in China’s equity markets,” said the authors of the firm’s latest research white paper, Future Shock: How China’s Reforms Are Creating Disruptive Risks (and Opportunities).

“Add to this the fact that the country’s growth continues to slow and the government faces immense challenges in implementing its reform programme, there can be little doubt that China poses short-term risks to investors.

“But just as it would be naïve to overlook the potential downside for China, so it would be easy, in our view, to focus on the negatives and ignore the positives.

“These include China’s extraordinary capacity to marshal its social and economic resources in the pursuit of its policy objectives—an attribute which, since 1978, has enabled the country to lift more than 500 million people out of poverty.*”

The paper, by Hayden Briscoe, Director—Asia-Pacific Fixed Income, Anthony Chan, Asian Sovereign Strategist—Global Fixed Income Research and Stuart Rae—Chief Investment Officer, Asia-Pacific ex Japan Value Equities, seeks to add balance to the frequently negative public debate about China’s economic and investment prospects.

• China’s currency, the renminbi, will become almost as important as the US dollar as a global trade settlement currency, and on par with the Swiss franc as an international reserve currency for Asian banks

• Economic growth of 5%‒6% a year—well below the double digits of the past—will become normal for China; far from being deterred, however, international investors will be attracted to the economy’s greater stability and diversity
• Investors will need to make big changes to their portfolios when China is included in global market indices (the full inclusion of China shares in global equity indices, for example, will increase China’s share of emerging market indices from around 20% to 30%)
• Investors who are early to the China opportunity will do well from sector plays such as consumer cyclicals and staples, healthcare and financial services. After the initial rush, the market will become less volatile and opportunities will be found in stock selection
• China’s manufacturers will innovate and move up the value chain so that “Made in China” will become a badge of superior, rather than inferior, product quality. Its consumers will set trends that those in the West—particularly the young—will want to follow
• The country’s push to exercise “soft power” through institutions such as the new Asian Infrastructure Investment Bank will lead to geopolitical realignments, particularly in Eurasia and some parts of Eastern Europe, and to new investment opportunities in those regions.

The authors sound a note of caution, however, observing that these disruptive changes will need to take place in the next two or three years for investors to be confident that China is indeed on track to complete the reform process which, they believe, will take a decade or more.

“Given the pace of China’s reforms to date—which has outrun many people’s expectations and surprised even us on occasion—we believe that the country has a better-than-even chance of turning its aspirations into reality,” said the authors.

“We believe that the best way for investors to position themselves ahead of such an event is to devote even more effort to researching the risks and opportunities that China represents.”

The post Despite uncertainty and volatility, China’s reforms could trigger six world-shaking changes, says AB appeared first on AdviserVoice.

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

———–

The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material, or an offer or solicitation for the purchase or sale of, any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. References to specific securities are provided solely in the context of the analysis presented and are not to be considered recommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors and companies described herein. This document is not an advertisement and is not intended for public use or additional distribution. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

The post The case for a robust RMB strengthens appeared first on AdviserVoice.

The key to this outcome is that the Chinese government remains committed to its far-reaching economic and financial reforms, said Hayden Briscoe, Director—Asia Pacific Fixed Income.

“While the policy balancing act in pursuing reforms and keeping the floor under economic growth is a difficult one, the Chinese government has so far succeeded,” said Briscoe. “Given the importance and potential benefits of the reforms, we believe the government will stay focused on the challenge.”

Major reforms are the internationalisation of China’s currency, the renminbi (RMB), and liberalisation of its capital markets. For China, the imperatives for reform are international as well as domestic.

“The global financial crisis, and the difficulty it caused for exporters and importers in accessing US dollar finance, taught China the limitations of conducting its trade in US dollars,” said Briscoe. “As a result of government actions since then, 20% of China’s global trade is now settled in renminbi (RMB). We see potential for that to increase to 50% in the next few years.”

By liberalising its capital markets China could mitigate the political sensitivity of needing to hold much of its nearly US$4 trillion in foreign exchange reserves in US government bonds. The US government has frequently accused China of buying Treasuries to keep its currency “undervalued”.

“One way to mitigate this would be for more of China’s claims on the US to be denominated in RMB, and one way for China to encourage foreigners to borrow in RMB is by liberalising the country’s capital markets,” said Briscoe. The move would eventually lead to China’s bond and equity markets being included in global indices, forcing significant country reallocations in global index-based portfolios.

Domestically, the next significant reform was expected to be the introduction of deposit insurance. “Policymakers hope it will encourage households to engage more with smaller banks as a safe alternative to the dominant five major banks, and help create a more dynamic banking sector which will be crucial to China’s economic rebalancing,” said Briscoe.

The post China on track with reforms, says AllianceBernstein appeared first on AdviserVoice.