News In Charts: PBOC Intervening To Put A Floor Under the RMB…For Now

China saw the largest net outflow of capital on record during the final three months of last year. For now, the authorities are intervening to put a floor under the RMB. Sales of reserve assets by the PBOC were also the largest on record. If the dollar peg is maintained, then China will internalise the pain of its hard landing. Ultimately, the temptation to allow a more rapid depreciation will prove too much to bear.

As regular readers of this column will be aware, we believe that a hard landing for China’s economy has become inevitable. What is at issue now is the policy response. Further reductions in official rates of interest are the obvious first move. But as we set out in the News in Charts summary of our latest forecast, our central view is that ultimately the PBoC will let go of the dollar peg, and allow the RMB to depreciate substantially. In this Newsletter, we review China’s balance of payments data for the final quarter of last year. They suggest that there is already considerable downward pressure on the RMB, with investors looking to withdraw funds from China. For now, it seems that the authorities are acting to slow the depreciation by selling foreign exchange reserves. At some point, and before the year is out, we expect them to throw in the towel and let the currency fall. The alternative is a far bleaker outcome for China, with much weaker growth, and much larger falls in prices.

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RMB drifting lower

The renminbi has fallen in value against the dollar by almost 1% since the beginning of this year, and by just over 2% since October. Small moves, perhaps, but they go against a trend that had been in place for the best part of ten years. The depreciation of the RMB since the autumn has been accompanied by a significant net withdrawal of funds from China. The deficit on the capital and financial accounts through Q4, at $91.2 billion, was the largest on record, as our second chart shows. In our view, this has been driven by falling sentiment regarding China’s economy, the prospect of further interest rate cuts, and a growing expectation that the RMB will be allowed to fall – perhaps significantly.

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For countries in a floating exchange rate regime, the current account and the capital and financial accounts of the balance of payments will tend to balance. They will sum to zero, or something close to it. The difference, measurement errors aside, is the change in official reserves. And in China’s case, this particular component has been very large.

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Since joining the WTO in 2001, China has run a series of large and persistent current account surpluses. That much is well known. At the same time, it has tended to attract net inflows of capital as global investors have sought greater exposure to what was rapidly becoming the world’s largest economy. In order to prevent a substantial appreciation of the RMB, the PBOC built up large quantities of foreign exchange reserves, as our third chart shows. During the final quarter of last year, however, these flows went into reverse. The PBoC made the largest net sale of official reserves since at least the late 1990s, when these data were first collected. For now, China’s authorities are leaning against some of the downward pressure on the RMB, though not by enough to keep the currency stable. It is worth noting that, at current levels of intervention, the currency has been falling at an annual pace of more than 5% since October. According to US Treasury Undersecretary for International Affairs, Nathan Sheets, in bilateral talks held during the summer, China committed to reduce foreign exchange market intervention. ‘By our reading, China has essentially refrained from foreign exchange purchases since that period,’ he said earlier this month. Quite. Far from purchasing foreign exchange, they appear to be conducting large-scale sales in order to stem the decline in the RMB.

In March 2014, and coinciding with its decision to widen the trading band for the RMB against the US dollar, the PBoC stated that risks to China’s financial system were ‘under control’ – the country’s substantial foreign-exchange reserves could be relied on to serve as a buffer against external shocks. It would appear that this buffer is now being used. The authorities have, for now, chosen to pursue Deng Xioping’s maxim of ‘crossing the river by feeling the stones’. They are pursuing a gradual and selective approach to market liberalisation. But, if the dollar peg is maintained, or loosened only very gradually, then China will internalise the pain of adjustment from a hard landing. That would lead to a prolonged period of deflation, and even weaker growth. Ultimately, the temptation to allow a more rapid depreciation will prove irresistible, in our view.

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.