On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.  Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks.  In fact, the RMB has strengthened recently which seems to have caught many off guard.  We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks.  My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month.  In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see.  This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens.  The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD.  Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen.  The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks.  Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to.  As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants.  For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months.  Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive.  Before August 11, when there was no expectation of future weakening, the spread was large.  Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening.  Spreads on various futures products remain tight even as markets continue to expect longer term depreciation.  Traders continue to report difficulty executing trades at posted prices for various products.  Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation.  Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate.  As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation.  It is worth noting that the RMB outflows have slowed, but still continue.  Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed.  However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock.  The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.

Robots and Trade from BloombergViews

I wanted to follow up to my piece from BloombergViews on robots reshaping international trade and development strategies of emerging markets.  As usual, start there and then come here.

  1. I am an international trade professor by specialty though I teach other subjects and the importance of this first hit me when I was reading Tyler Cowens Marginal Revolution a while back about Foxconn threatening to automate its plants. He made the point, why do they need to manufacture in China as a robot costs the same to employ whether in China or the United States. This hit me like a lightning bolt.
  2. Now some have pointed out, and they are correct, that even if a robot costs the same to employ the world over, there are other factors involved in relative costs. This is entirely true but there are a couple of important caveats to this. First, this still equalizes a large portion of the cost differential. In the US labor captures about 2/3 of GDP so that is a pretty large amount.  In many of the low skilled industries like garment manufacturing, labor represents a not insignificant slice of the cost differentials.  I am in complete agreement that it does not equalize all costs and productivity, but it has a large impact.  Second, many of the related productivity inputs are better situated in countries that already have large productivity advantages or can be reshored easily.  Not all industries for sure but it is very difficult to see how this is not the general case.  If we take the iPhone, with components from all over the world, other than building the factory, there do not seem to be a large number of impediments to shifting production someplace else.  Even garments seem to have little fundamental attachment to location as long as the manufacturing cost is similar.  Even many of the related aspects that impact production cost seem to be better placed in developed economies. Whether it is ease of transport, infrastructure, or high skilled labor, developed economies seem better placed to benefit from robotic development.
  3. It also seems much more likely that this will exacerbate inequality. Think about it like this.  Computer scientists and industrial engineers in developed countries will be taking jobs from low skilled peasant migrants in developing countries to make garments.  Even the capital needed to build these plants will come from well paid bankers and other investors.  In other words, this seems very likely to increase both across and within country inequality as the low skilled get displaced by the high skilled.
  4. Rather than trade policy being a driving factor, human and financial capital agreements seem to the new agreements. If you want to leap frog, you need to attract global talent and capital to build these plants.  That is a very different thing than the detailed trade agreements we have today.

Taking it a little bit easy right now in the summer but hope to post some more things soon.

Bloomberg and Left Behind Children

I am enjoying some down time in the States but still bouncing around doing some work so over the summer, I may not update the blog as much.  Baseball games, fireworks, New York City, and middle America are all on the docket for me this summer.

I wanted to write some follow up notes to my BloombergViews piece on left behind children in China.  As usual, start there and come here for follow up.

  1. So often, people that study China, outside observers, and even those of us that live and work there think of China as a developed country. However, and I do not mean this in a critical way, it is not and we too often forget that. Lost amidst the new airports and high speed rail is the fact that nearly half of the population is still only slightly above subsistence farming.  Again, I do not mean that as a critique as China has made enormous strides over the past few decades, but as a recognition of fact.
  2. I’ve gotten a couple of emails asking why I’m picking on China and let’s assume that I am, I don’t think I am but let’s assume that I am, issues like left behind children are a long run inhibitor to Chinese economic development. This cognitive and mental problems impact nearly 1/3 of Chinese children.  The gap between rural and urban children is enormous and will impact the ability of China to meet its long term economic objectives.  I may be critical of China but it needs to solve these problems to become an advanced economy.
  3. What astounds me is that this is essentially driven by a government policy that almost requires splitting up families. I find this a personally abhorrent policy.  What government creates and accepts a policy that encourages families to be divided?
  4. Even beyond the left behind children, the status of rural vs. urban children is amazingly different.   These are major issues for China.

Some Random Thoughts for China:

  1. July data is very weak.
  2. Credit is practically the only driver of the Chinese economy.
  3. GDP data remains incredibly suspect.
  4. FX data is incredibly difficult to reconcile.
  5. Worrying that credit explosion having so little impact on real economic activity.
  6. Decline in exports and imports is not just related to low global demand and anyone who says so is lying.
  7. Corporate revenue in Chinese industry is bad in 2016.
  8. Retail numbers are bogus.

I’m working on a more detailed piece about Q2 GDP which I hope to release next week.  It’s coming.

For now, I’m off to start drinking some good old American craft beer.

How PBOC Making FX Reserves Look Better Than They Really Are

The PBOC has released foreign exchange reserves data and the results are puzzling.  Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results.  Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.

There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.

  1. According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP.  While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
  2. Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase.  Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion.  Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
  3. However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015.  Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
  4. Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms.  HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
  5. Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions.  Theoretically, this should result in ever expanding offshore liquidity.  Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits.  Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
  6. Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
  7. This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB.  It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland.  Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
  8. We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.”  What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%.  It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%.  The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning.  Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.

We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.

Revisiting Chinese Balance of Payments and RMB Pressures

Despite all the attention focused on the credit woes of China, and there are a lot, the state of the RMB remains my biggest concern.  China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most.  Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.

China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB.  The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.

  1. Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates.  In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014.  These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
  2. If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow.  It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency.  Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion.  In the past two years this amount rises to 2.35 trillion or $351 billion.  If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure.  In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
  3. BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital.  BOP records a 679 billion RMB surplus in goods trade.  SAFE and Customs report a 694 billion and 810 billion trade in goods surplus.  In other words, official BOP data is highly correlated with other official data like Customs and SAFE data.  However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows.  In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting.  This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus.  If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
  4. In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing.  In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data.  Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015.  Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story.  What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio.  By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion.  In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion.  However, within this asset basket, we have seen a significant rebalancing.  The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets.  As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion.  These offsetting changes explain the entire growth in OFDI and decline to total assets.  Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets.  Those are two contradictory data events.
  5. One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows.  Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.