China Returns

Twilight urban skyline of Beijing Guomao,the capital city of China

China’s markets have been closed since the end of September and re-open tomorrow. It is interesting to note what has happened in the global capital markets in the interim.

The US dollar has fallen against all the major currencies, but the Japanese yen is off about 0.2%. Major equity markets are 3%-5% higher. US and Germany benchmark 10-year bond yields are up about 3 bp, though UK gilt yields are up 9 bp, with half of this gain being recorded today. Many industrial commodity prices are higher, with the price of Brent up a little more than 9%, and the CRB index up 4%.
Arguably, two of the most important developments since China’s holiday began are the weakness in the US employment data and, leaving aside the UK, output of the major economies appeared to slow in August.   Although many market participants have shifted their expectations of a Fed hike out to March 2016, many Fed officials themselves continue to signal the likelihood of a rate hike before the end of the year.

The Hang Seng China Enterprise Index, which is comprised of Chinese shares that trading in Hong Kong has risen by 10.5% since the mainland markets closed.   Recall that in September the Shanghai Composite was bouncing along the trough that was set in August.  It traded between 2983 and 3215.  A trendline connecting the June (~5178) and the August (~4006) high comes in tomorrow near 3192.

Earlier today, China reported that its reserves fell to $3.514 trillion, a $43.3 bln decline over the course of the month.   This was a somewhat smaller decline than market participants expected. However, if the PBOC intervened in the forward market, perhaps trying to force a convergence between the onshore and offshore yuan, as many suspect,  the impact in reserves would not be immediately evident.

Some observers insist that the decline in PBOC reserves also understands the capital outflows because, given the large trade surplus, reserves should have risen.  That may have well been the case previously, but the liberalization measures weaken this link.  Chinese businesses appear to have greater latitude in converting their foreign currency earnings.  Less of it may be winding up in the PBOC coffers.
The dollar value of China’s reserves is impacted by the fluctuations of the foreign exchange market.   The value of China’s reserves peaked last June near $3.993.2 trillion.  They have fallen 12% to $479.09 bln since.   The euro, for example, has fallen 18.3% since then (through the end of September).  For the purpose of this exercise, if we make a conservative assumption that 20% of China’s reserves were in euros, the valuation adjustment reduced China’s reserves by $147 bln.

This is to say that the depreciation of the euro can account for almost a third of the decline in the valuation of China’s reserves.  During this period, sterling lost 10.5% against the US dollar, the yen fell 15.6%, the Canadian dollar depreciated by almost 18%, and the Australian dollar fell 23.4%.   The valuation drag on China’s reserves is frequently not incorporated in discussions of the decline in China’s reserves.

In addition to the evolution of the Chinese economy and stock market, investors are watching two other developments.  First, next month MSCI will begin a two-step process to include 15 of the most active Chinese ADRs into their global indices. Half will be included in November and the other half next Spring.  Second, is the IMF’s formal decision on the inclusion of the yuan in the SDR.  That decision is expected next month.

Much of China’s financial reforms in recent months appears aimed at facilitating its inclusion into the SDR.  We think China’s main interest in being included in the SDR is prestige.  It signals the emergence of China as a global financial power.   Some observers think that if it is included in the SDR, foreign central banks will more likely boost their yuan reserves, which the IMF estimates to be about 1.1% of global reserve or roughly $124.6 bln, to triple or quadruple in the next few years.  This seems a bit exaggerated given central banks typically glacial moves.  Moreover, global reserves are unlikely to grow as they have over the past decade.

The SDR decision requires a 70% majority vote.  This means that the US will not have a veto.  In order to block the yuan’s inclusion, a bloc that includes the US, Japan, and several other countries would be needed.  The US position as stated by Obama and Lew is that the  US will not oppose China’s inclusion, if it meets the IMF requirements.     The significant exporter criteria is easily met.  The key requirement is whether it is “freely usable” for international transactions.

It is a judgment call, and we suspect that the odds favor the yuan’s inclusion with a relatively modest weighting to begin.    The new composition of the SDR will not be implemented until September 2016.  Given that Chinese interest rates are higher than other SDR members (US, EMU, UK and Japan), it would on the margin increase the cost of borrowing from the IMF.