China: More Eases and Shifting FX Policy

Published on December 10, 2015
SGH Insight
"Meanwhile, in the near term, economic officials believe expectations of a Fed rate hike on December 16 will keep upward pressure on the dollar, and so the PBoC will remain judicious, on and off, in its interventions in order to avoid blowing through even more valuable FX reserves in fighting those pressures than it already has. Once the Fed and CEWC meetings are out of the way by December 20, however, the PBoC may resume more aggressive action to manage the currency back closer to what it originally had in mind as a target for year-end of around 6.4000."
Market Validation
(Bloomberg 12/16/15) -- "The yuan rebounded from early losses in Hong Kong’s offshore market, spurring speculation Chinese policy makers are propping up the currency after its discount to the onshore spot rate doubled. The yuan was trading 0.05 percent stronger at 6.5280 a dollar as of 4:33 p.m. in Hong Kong, after sliding as much as 0.19 percent, according to data compiled by Bloomberg. It erased the drop within 15 minutes of reaching the day’s low. In Shanghai’s onshore market, the yuan fell for a ninth day, the longest run of losses since at least 2007, to close at a four-year low of 6.4733. A major Chinese bank placed a "sizable bid" for yuan at around 6.53, triggering the rebound in the offshore rate."

President Xi Jinping of China is reported to have outlined his top three policy priorities for 2016 to a meeting of the Central Financial Leading Group for 2016 boosting employment, income growth, and improving the environment.

But quite surprisingly, we understand that Xi is also said to have suggested the CFLG at least consider pushing their growth target up to an extremely ambitious 7% GDP target for 2016 at the upcoming Central Economic Work Conference scheduled for December 18-20.

*** Meeting those targets, if adopted, or even hitting a high 6% growth rate in light of continued soft data, is clearly not without considerable risk, and that, as well as the upcoming Federal Open Market Committee meeting on December 15-16, underlies what appears to be a clear pullback recently in interventions to keep the Renminbi from depreciating, as well as a subtle shift in messaging on Beijing’s currency prospects and policy objectives for 2016. ***

*** It also from what we understand has led to active consideration of a cut by the People’s Bank of China in the RRR rate in December, with a potential further cut in interest rates in January. ***

*** The PBoC has, we believe, teed up a cut of 50 basis points in the “universal” Reserve Requirement Ratio (RRR) for banks, plus another 50 basis points cut on top of that for certain commercial banks focused on lending to farmers and small business enterprises, if needed, for this month. The PBoC would also consider another cut in its benchmark interest rates but there is a concern that in light of the likely Fed tightening a rate cut in December would lead to a dangerous further bout of RMB depreciation. Our understanding therefore is that the PBoC will, unless instructed otherwise by the leadership, consider a 25 basis points rate cut in January, probably in the second half of the month. ***

*** And on the Renminbi, the message from Beijing appears to have shifted from assurances of a stable, strong, and potentially even slightly stronger RMB outlook in 2016 to assurances there will be no “sharp” or “one-off” depreciation in the currency that could trigger the dreaded currency wars. Officials now concede the RMB may indeed continue to weaken against the dollar for most of next year, even if it ends up relatively strong, presumably on the back of a stabilizing economy, later in 2016. ***

*** Meanwhile, in the near term, economic officials believe expectations of a Fed rate hike on December 16 will keep upward pressure on the dollar, and so the PBoC will remain judicious, on and off, in its interventions in order to avoid blowing through even more valuable FX reserves in fighting those pressures than it already has. Once the Fed and CEWC meetings are out of the way by December 20, however, the PBoC may resume more aggressive action to manage the currency back closer to what it originally had in mind as a target for year-end of around 6.4000. ***

Skeptical analysts and investors may see a 7% GDP target as widely off the mark, but this push from Xi is intended, if adopted, to serve mainly as a confidence building exercise and to signal a policy commitment to maintain reasonably healthy growth rates.

Indeed Xi is said to believe that whatever the target, China more realistically has the capability to maintain a 6.7% – 6.8% growth rate for 2016, and economic officials expect to end Q4 2015 at around a 6.9-7.0% GDP growth rate despite facing  unquestionable headwinds and risks to the forecast. Among those risks, listed in a report outlining eight major risk points for 2016 compiled and presented last week to the Politburo, are an RMB devaluation, commodity collapse, and deflation.

Eight Risks to the Economy

In preparation for the meeting of the Central Economic Work Conference on December 18-20 the General Office of the Central Leading Group for Comprehensively Deepening Reform (we did not make the name up) submitted a list to the Politburo of the CPC Central Committee and State Council last week of the top eight potential risks to China’s economy in 2016, along with some broad recommendations.

Those risks were listed as: deflation, RMB devaluation, local government debt, a property market slump, a global commodity price collapse, industrial overcapacity especially in the mining sector, a small scale military conflict in the South China Seas, and terrorist attacks from the Xinjiang (Uyghur) Autonomous Region.

Deflation – The study concludes that although China has not fallen into deflation, the risk is rising and poses a greater danger than inflation. It suggests policymakers take measures to ensure inflation does not fall below 1.5%, including further increases in government spending and growth-oriented tax breaks. But while 1.5% inflation seems clearly to be a level of sensitivity, we are not aware if this report outlines recommendations on the monetary policy side, including the planning that we have separately highlighted above.

RMB Devaluation – The study concludes that the RMB will continue to face unprecedented depreciation pressures against the dollar next year, with full expectations of Fed tightening cycle starting at its upcoming December 15-16 meeting. Authorities are, however, still keenly sensitive to the risk of massive capital flight out of China, and in order to prevent that without blowing through reserves as they have to date due to large-scale interventions, the policy and message appears to have shifted to one of “bending with the wind” as opposed to an outright battle with the markets.

And to that point, the study recommends policy makers ensure “a sharp depreciation” of the RMB does not happen in China, and suggests a message be delivered to the US that the Fed continue to take into consideration the viewpoints of the PBoC and other foreign central banks in setting its policy for 2016. Policymakers appear already to be shifting their assurances to more limited promises the RMB will not have a sharp or one-off depreciation in 2016, but will likely continue to weaken – against the dollar at least – in 2016, perhaps to strengthen later in the year presumably on the back of stabilization in growth rates and prospects.

Local Government Debt – The days of popping local government debt bubbles appear well behind us, and indeed this study rather focuses on addressing the risk of repayment concerns and preventing indebted local governments from now causing a financial system crisis. It specifically recommends that the central government authorize the Ministry of Finance to approve around 3-4 trillion yuan in additional debt-swap quotas for provincial governments to convert maturing high-cost debt into lower interest bearing municipal bonds in 2016.

Property Markets – Gone also are the days of worrying about real estate bubbles (even if still a concern in some targeted markets), and this report rather focuses on addressing the problems of overcapacity and overhang. It notes there were 437 million square meters of finished homes on the market as of October, with a whopping 3.57 billion square meters of unfinished homes in the pipeline. The study recommends that in order to prevent the property market from deteriorating further, which would be a serious drag on the economy, the central government should pledge a deep cut in housing inventory (we are not sure of the details and how).

Global Commodities – The report expects the price of commodities to fall further across the globe as the dollar continues to strengthen. It recommends the government work with natural-resource rich countries to take unspecified joint measures to prevent prices from plummeting further, limit China’s own domestic output in major natural resource industries, and in the meantime take advantage of low prices by significantly increasing agricultural and natural resource imports.

Industrial Overcapacity – The report acknowledges that the transition from an industrial based economy to one featuring service industries and technology as its main growth drivers has been a difficult one, and the phase of overcapacity will be long and a painful one to overcome. It recommends the government focus on cutting back on overcapacity in traditional industries, and recommends it export at least 500 billion yuan worth of industrial equipment overseas to developing countries.

Small Scale Military Conflict in South China Seas – The report not surprisingly suggests the leadership continue to press the US government not to challenge China’s sovereignty over the South China Seas. Separately, Chinese sources have indicated they may take tougher action against US naval ships next time they cross into the 12 nautical mile navigation space of the disputed South China Sea reefs than they did when the USS Lassen entered the waters of the “Zhubi Jiao” (Subi Reef) last month.

Specifically, they warn the PLA navy will directly “expel,” rather than tail, any US ships in those waters next time. Of course through the tough talk they also stress the PLA Navy is maintaining an open dialogue with the US Navy, exactly in order to avoid any such clashes over the next few months.

Xinjiang Terrorist Attacks – The report warns there is evidence that the Uyghur ethnic group Muslim separatists are planning terrorist attacks that could cause social unrest and threaten national security in 2016, and encourages strict measures be taken proactively to avoid those, to the extent possible.

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