China Likely to Muddle Through

With China’s markets closed this entire week for holiday, we thought this was a good time to step back and assess how things stand in the Middle Kingdom. September PMI data released over the weekend suggest that the economy continues to slow. Indeed, growth may slow more than desired but we do not foresee a hard landing that would upset global markets.

POLITICAL OUTLOOK

Trade tensions remain high. Last week, the US enacted the latest round of tariffs on $200 bln of Chinese imports, set at 10% initially and rising to 25% on January 1. As expected, China imposed retaliatory tariffs on $60 bln of US imports on the same day. The US threatened tariffs on a further$267 bln of Chinese imports if China were to retaliate. However, the US has not made any further announcements.

US-China relations have worsened further. President Trump at the UN accused China of meddling in the upcoming US elections, claiming that there is evidence. Trump even suggested that he and President Xi may no longer be friends. Trade talks were canceled over the weekend, and the recent turn of events suggest that real ill will is building up on both sides. China officials canceled planned trade talks in Washington last month, saying negotiations could not be conducted in the current environment of threats and retaliation. Markets should be prepared for a protracted trade war.

China’s Premier Li promised not to weaken the yuan to stimulate exports. He added that a one-way devaluation will do more harm than good to China, and we concur (see section below on the 2015 yuan devaluation).

 

A BRIEF HISTORY LESSON

Renminbi and yuan are often used interchangeably to describe China’s currency. Renminbi translates roughly as “the people’s money,” while yuan is the base unit. A useful comparison would be sterling and pound; the first is what the UK refers to as money, while the pound is the base unit.

The renminbi was introduced in 1948 by the People’s Bank of China (PBOC), almost a year before the founding of the People’s Republic of China. As the Communists gained control of greater and greater portions of the country, they replaced the various regional currencies that were circulating with the renminbi. For most of the early years, it was pegged at 2.46 per dollar but was sporadically revalued until the rate reached 1.5 per dollar in 1980.

While there were several minor devaluations during the 1980s, China upended the global economic order with its massive 33% devaluation in January 1994. Coupled with an aggressive export-led development plan, China saw its GDP quadruple in size from 1993 to 2008. GDP growth averaged 10.5% per annum during that period. The yuan remained pegged at roughly 8.3 per dollar until 2005. Indeed, during the Asian Crisis of 1997, China policymakers steadfastly maintained the peg.

Official policy changed with the de-pegging of the yuan in July 2005. A managed float followed, but this stalled during the Great Financial Crisis, when the PBOC re-pegged the yuan at around 6.83 per dollar in July 2008 in order to inject stability into an otherwise chaotic global backdrop. The yuan was unpegged again in June 2010 and continues to be run as a managed float.

The yuan was last devalued in August 2015. The move unsettled global markets and led to significant capital outflows from China. Foreign reserves fell from $3.7 trln in July to $3.2 trln in early 2016. This necessitated the tightening of capital controls, and foreign reserves stabilized.

Currently, spot CNY is allowed to trade 2% on either side of the daily fix. The fix itself is a bit of a black box, especially with the recent re-addition of the so-called “counter-cyclical factor” back in August. This allows the quoting banks to use non-market factors in submitting their fix rates. Note that the CNY counter-cyclical factor was phased out back in January.

China has been trying to increase the global role of the yuan since the Great Financial Crisis. The offshore renminbi bond market was first established in 2007. These were dubbed “dim sum” bonds. After an early surge in issuance, the market has slowed in recent years. Issuance can take place in Taiwan, London, Singapore, and Frankfurt, but the majority is seen in Hong Kong. Issuers from nearly 40 different countries have sold dim sum bonds, but Chinese entities make up the lion’s share.

Offshore CNH was first introduced in July 2010. The PBOC and the Hong Kong Monetary Authority (HKMA) made a joint announcement then that the RMB would be made deliverable in Hong Kong. This offshore program has since been expanded to major financial centers such as Singapore, Taiwan, and London.

CNH is freely tradeable but is still influenced by the PBOC via liquidity conditions. It was recently announced that China plans to work with Hong Kong to sell yuan-denominated bills offshore. This would allow the PBOC to better control offshore liquidity and therefore influence the offshore CNH rate.

 

ECONOMIC OUTLOOK

The mainland economy is still slowing. GDP growth is forecast by the IMF at 6.6% in 2018 and 6.4% in 2019 vs. 6.9% in 2017. GDP rose 6.7% y/y in Q2, matching cycle lows from mid-2016. In light of the building global headwinds, we see downside risks to the growth forecasts. However, our base case remains that China muddles through. That is, growth may slow more than desired but we do not foresee a hard landing that would upset global markets.

Over the weekend, both official and Caixin PMI readings for September were both reported weaker than expected. Official manufacturing PMI fell to 50.8 from 51.3 in August, while Caixin manufacturing PMI fell to 50.0 from 50.6 in August. The headline Caixin reading was the lowest since May 2017. The output component was the lowest since October 2017, while the new orders component was the lowest since June 2016.

Price pressures are rising. CPI rose 2.3% y/y in August. This is the highest non-Lunar New Year rate since November 2016. The PBOC does not have an explicit inflation target. However, it is now clearly focused on supporting growth, not fighting inflation. The PBOC said recently that it will maintain a prudent and neutral monetary policy for now. It said it would maintain reasonable and ample liquidity whilst acknowledging “more severe” global challenges.

The PBOC last injected stimulus back in July. The bank instructed commercial banks then to increase lending to local companies, particularly those that were struggling. Official policy rates have been kept steady since the last 25 bp cut back in October 2015.

The fiscal outlook bears watching. Prime Minister Li vowed to cut taxes and administrative fees further in order to support the real economy. This, along with increased state spending, will put upwards pressure on the budget deficit. The deficit was -3.7% of GDP in 2017, and the IMF sees it remaining near this level in both 2018 and 2019. We see upside risks given the emphasis on fiscal stimulus.

The external accounts are deteriorating modestly. The current account surplus was 1.3% of GDP in 2017, and the IMF expects it to narrow to 0.8% in 2018 and 0.6% in 2019. However, export growth has been slowing noticeably this year even as imports remain robust, leading the trade surplus to narrow. This points to downside risks to the surplus forecasts.

Foreign reserves have stabilized but remain well below record highs. At $3.1 trln in August (down from the all-time high of $4 trln in mid-2014), reserves cover over 17 months of imports and are three times the stock of short-term external debt. Thus, the country is not very vulnerable to shifts in sentiment and so-called hot money. In addition, China’s Net International Investment Position (NIIP) is a respectable 12% of GDP.

 

INVESTMENT OUTLOOK

Have efforts to boost CNY globalization succeeded? According to IMF Composition of Official Foreign Exchange Reserves (COFER) data, the answer is yes. Latest data for Q2 shows that the renminbi’s share of total allocated reserves rose to 1.84%, the highest on record. It overtook AUD (1.7% share) and is closing in on CAD (1.91%).

There has been no 100% predictable relationship between CNY and CNH. While the two are highly correlated (at 0.86 currently), the spread tends to oscillate. There have been extended periods when CNH trades below CNY, and vice versa. However, since CNH’s inception, its under- and overvaluation with regards to CNY has basically been symmetrical in terms of the probability distributions.

We note that there have been two periods of significant CNH deviation from CNY, and both times saw USD/CNH trade above USD/CNY. The first took place from September 2011 to January 2012. The second took place from August 2015 to February 2016. This second phase was a particularly turbulent period for Chinese markets, as the August 2015 devaluation led to a significant spike in volatility and capital outflows.

Eventually, the two exchange rates should converge as China opens up its capital account. Until that happens, though, divergences are likely to persist. And one can ask whether we will ever see full convertibility. In many ways, we think the development of the offshore bond and currency markets is a back-door way for China to partially open up its capital account without introducing full convertibility.

CNY is trading in the middle of the EM pack after a strong 2017. In 2017, CNY rose 7% vs. USD and was only slightly behind the best EM performers KRW (13%), MYR (11%), THB (10%), ZAR (10%), and TWD (8.5%). So far in 2018, CNY is -5%. Compare this to the best performers MXN (+4.5%) and THB (+0.5) as well as the worst performers ARS (-51%) and TRY (-36.5%). Our EM FX model shows the yuan to have VERY STRONG fundamentals. However, USD/CNY is on track to test the December 2016 high near 6.9650.

Chinese equities are underperforming after a stellar 2017. In 2017, MSCI China was up 53% vs. 34% for MSCI EM. So far this year, MSCI China is -12.5% YTD and compares to -10.5% YTD for MSCI EM. Our EM Equity Allocation Model puts China at VERY OVERWEIGHT, and so we expect Chinese equities to start outperforming.

Chinese bonds have outperformed. The yield on 10-year local currency government bonds is -28 bp YTD. This is behind only the best performer Chile (-36 bp). With inflation likely to remain low and the central bank maintain its dovish stance, we think Chinese bonds will continue to outperform.

Our own sovereign ratings model shows China’s implied rating steady at A+/A1/A+. S&P’s downgrade last year to A+ moves it into line with our model, as well as with Moody’s and Fitch.