China: The “PetroYuan,” Fed, and Growth Expectations

Published on May 26, 2016

Key Takeaways:

•    After months of preparations, China will soon begin invoicing all its crude oil imports in yuan rather than in dollars.

•    The PBoC is taking “pre-cautionary” measures against any sharp RMB depreciation when the Federal Reserve hikes this summer, probably July.

•    Beijing remains confident in its growth forecasts, and that aggregate debt levels remain tolerable.

Two important currency policy changes are being prepared by Chinese officials that we want to flag:

*** After months of preparations, Chinese officials are moving ahead with a plan to shift the invoicing of Chinese oil imports from US Dollars to the yuan. Chinese officials will discuss the plan with Russian President Vladimir Putin when he visits Beijing next month, and most importantly, with Saudi and other Gulf Cooperation Council officials before year-end when the countries are expected to sign a free trade agreement. ***

*** In the nearer term, the People’s Bank of China is preparing “pre-cautionary measures” to prevent any sharp deppreciation of the RMB this summer when they believe the Federal Reserve will be raising rates, with their expectations leaning towards the hike coming in July (SGH 5/24/16, “China: Fed Hikes and the Sliding RMB”). Barring any surprise shocks, they also continue to expect a second Fed rate hike this year, most likely in December. ***

Meanwhile, after a recent review, Chinese officials remain confident they will meet the 6.5-7.0% government GDP target range for this year, with the second quarter coming in around 6.7-6.8%. And while sensitive to international concerns over China’s high debt levels, they believe the aggregate debt level remains tolerable, in part because local tax revenues have jumped in the first four months this year, enabling local governments to reduce their debt loads on top of the fiscal transfers from the central government.

Preparing for a Fed Rate Hike

In our report earlier this week (SGH 5/24/16, “China: Fed Hikes and the Sliding RMB”) that was subsequently picked up by news wires, we noted Chinese officials hoped at the upcoming meeting with their US counterparts at the Strategic and Economic Dialogue talks in Beijing on June 6/7 to get a clearer sense of the timing to the likely Fed rate hike this summer, whether June or July.

Chinese officials are expecting two Fed rate hikes this year, one in the summer, and a second before year-end, probably in December.

While the Chinese policy makers are not unduly stressed over the possible market reaction to the Fed’s modest hikes — believing markets will price that action in by the time it comes — there are some lingering concerns over its impact on the RMB and the economy.

Last December, for instance, when the Fed raised rates for the first time after seven years at the Zero Lower Bound, the RMB depreciated sharply by about 3% that month under speculative pressures surrounding the Fed rate move.

So while expecting and prepared for a second Fed rate hike this summer, Chinese officials are expected to advise the US officials of their preference for a rate hike in July, assuming the US economy continues to improve and Britain does not leave the European Union. While the two meetings are only some six weeks apart, the Chinese feel a July rate hike could be more easily absorbed by their economy and in the market’s pricing expectations compared to June.

In any case, the PBoC is prepared to take unspecified “precautionary measures” to prevent a repeated sharp depreciation of the Chinese Renminbi.

They expect the RMB to continue drifting lower as the dollar strengthens, seeking to manage the RMB/Dollar central parity rate at around 6.5000-6.6000 through July, and settling against the dollar at around 6.6000 by year-end. If growth comes in weaker than expected, the RMB may end closer to 6.7000.

Building a “Global PetroYuan”

Perhaps more significantly in the medium term, in an effort to enhance the yuan’s status as a global currency (and in the process creating FX demand), Chinese officials will soon be following through with their plans to completely shift their purchases of oil imports from dollars to yuan, or in what is now being termed the “PetroYuan” (see SGH 2/11/16, “China: A “Strong RMB” Strategy’).

The efforts to do so have been reinforced by the recent difficulties Iran has had in accepting dollars for payment for oil exports to China for some time due to the ongoing US financial market restrictions despite the lifting of oil sanctions.

Chinese officials now plan to discuss moving away from payment in dollars for oil imports with Russia as well. From what we understand, they will bring that up during President Vladimir Putin’s upcoming visit to Beijing next month, and expect ready agreement from Moscow.

And most significantly Beijing plans to press Saudi Arabia and oil producing countries of the Gulf Cooperation Council to follow suit when China and the GCC sign a free trade agreement at the end of the year.

Growth and Debt

On the overall prospects for the economy, Chinese officials remain cautiously optimistic, expecting the next three quarters to out-perform market expectations and to meet the government target GDP range for this year of 6.5-7.0%. More specifically, they expect Q2 GDP to come in around 6.7-6.8%, and full year GDP for 2016 to end up at around 6.7%.

While officials are aware of and sensitive to international criticism and concerns over China’s high debt and leverage levels – according to the PBoC total Credit to GDP ratio hit 230% today – they believe the aggregate debt level remains tolerable.

They will continue to point to traditionally high savings rates, an underdeveloped stock market that pushes money into savings, and the 4 trillion CNY stimulus package as explanations, all of which they maintain can be eased through structural reform measures.

Premier Li Keqiang furthermore has acknowledged and will stress that all levels of government should work on alleviating the high debt and leverage ratio problem in a “gradual and healthy way,” including, for instance, by channeling more savings into the corporate sector, and through higher growth.

Indeed, local governments report that assistance from the central government from the debt to bond swap program has helped significantly alleviate their debt burden.

But perhaps far more significant and encouraging than a reduction of local debt through a transfer to central government liabilities, they are also reporting fiscal revenues have already jumped significantly for the first four months of this year, largely on the back of a recovering housing market.

Private investment, on the other hand, remains sluggish and is a source of concern.

President Xi Jinping and Li Keqiang will therefore task the National Development and Reform Commission and all 31 provincial governments to issue a number of policies to encourage private investment in the real economy starting June 1.

The overall target will be to raise private investment from the lackluster 5.2% registered during the January-April period to over 10% for the year.

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