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GLOB
AL
M
AC R O R
ES
EA
RC
H •
FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL.PLEASE REFER TO THE IMPORTANT INFORMATION AT THE BACK OF THIS DOCUMENT.
GLOBAL MACRO RESEARCH CHINA'S EXTERNAL BALANCES: PAST, PRESENT AND FUTUREJUNE 2020
THE PAST
• Current account: The current account has shifted from substantial surplus to a state of near balance today.
Several factors account for this including a shift toward a more consumption-led growth model and an
increasingly negative services balance driven by higher levels of outbound tourism.
• Foreign direct investment: China was a consistent net recipient of foreign direct investment over much of the
last 30 years. This is no longer the case. Inflows have slowed down, while outflows have increased as China seeks
to strengthen its connectivity to the world.
THE PRESENT
• A massive investment undertaking: China’s Belt and Road Initiative involves vast foreign direct investment
outflows and is expected to involve over US$1trn worth of investments across many countries. If successfully
implemented, this initiative could help re-orient a large part of the world economy toward China.
• An unremarkable balance of payments position: Today, China’s external balances appear relatively
unremarkable when compared with those for other major economies.
THE FUTURE
• Current account: We expect further downward pressure on China’s current account as imports increase relative
to exports, while outbound tourism continues to accelerate.
• Income balances: The income balance position should remain broadly unchanged.
• Portfolio flows: China will likely have a greater requirement for external financing given the ongoing deterioration
in the current account. We expect portfolio inflows to increase as capital controls are eased.
• Foreign direct investment (FDI): We expect China’s net FDI position to continue to deteriorate, in part because
of the Belt and Road Initiative, but remain broadly neutral in terms of its contribution to the capital account.
EXECUTIVE SUMMARY
POLICY AND INVESTMENT IMPLICATIONS
A more open capital account: It seems likely that China will need to further relax its capital account
as it further integrates into the global financial system.
Currency: While a deteriorating current account should put pressure on the renminbi, we believe
capital inflows from Chinese bond and equity index inclusion and a drive to internationalise the
renminbi should make currency stability more likely.
Bonds and equities: Both Chinese bonds and equities should benefit from greater demand
technicals as they enter global investment indices.
3
Figure 1: The components of a country's balance of payments
UNDERSTANDING THE BALANCE OF PAYMENTSTHE BALANCE OF PAYMENTS, WHICH INCLUDES BOTH THE CURRENT AND CAPITAL ACCOUNT, RECORDS A
COUNTRY'S INTERNATIONAL TRANSACTIONS WITH THE REST OF THE WORLD. RUNNING DEFICITS ARE NOT
NECESSARILY A BAD THING. MANY COUNTRIES HAVE BEEN RUNNING THEM SUSTAINABLY FOR DECADES, AND
FOR LESS DEVELOPED ECONOMIES THEY CAN HELP SUSTAIN INVESTMENT AT A SUFFICIENT PACE TO INCREASE
LONG-TERM GROWTH.
3
A RECORD OF A COUNTRY'S TRANSACTIONS WITH THE WORLD
The balance of payments is essentially a record of a country's international transactions with the rest of the world. It consists of three components – the current account, the capital account and a balancing component, the errors and omissions. The current account represents a country's net income over a period of time, while the capital and financial account records the net change of assets and liabilities during a particular year.
By definition, these three components must sum to zero, but imbalances may exist between individual components. For example, this can take the form of excessive surpluses or deficits, which can place stresses on a country's economic model. The constituents of the current and capital accounts are outlined in Figure 1.
1 Trade balance of goods
and services
2 Net foreign income
3 Unilateral transfers
1 Foreign direct investment (FDI)
2 Portfolio flows
3 Broad definition includes
reserve account
4 Short-term banking flows
1 Balancing item
Current account Capital and financial account Errors and omissions =0+ +
4
THE IMPORTANCE OF THE BALANCE OF PAYMENTS
If a country maintains a current account deficit, it needs to borrow externally, and this
makes it vulnerable to swings in investor sentiment. That said, current account deficits are
not necessarily a bad thing. Countries have been running them sustainably for decades.
In emerging markets, for example, a sustainable current account deficit is often desirable.
The lower stage of economic development necessitates greater capital goods imports in
order to sustain investment to increase long-term growth potential. Problems may arise
when the current account is driven by unsustainable domestic or international policies.
We provide historical examples of such problems in Figure 2.
Figure 2: Notable balance of payments crises
Crisis What happened
Emerging Markets:
Asian Financial crisis
1997-98
During the 1990s several South East Asian economies maintained fixed
exchange rates versus the US dollar while maintaining open capital
accounts (i.e. there are no restrictions on moving money in or out of the
country). At the time, these economies were experiencing both rapid
economic growth and high rates of investment that were financed by large
current account deficits.
Companies, banks and governments borrowed mainly in foreign currency,
essentially the US dollar, and often at short maturities. This left them
vulnerable both to currency depreciation, because the local currency value
of their US dollar obligations would increase, as well as to funding risk,
because refinancing their short-term obligations left them susceptible to
changes in investor sentiment.
Ultimately a run on the Thai baht in 1997 led to devaluation, and contagion
swept through the region. Other South East Asian economies also abandoned
their fixed exchange rate regimes, devalued their currencies, lost
competitiveness and were burdened with increased debt servicing costs.
Developed Markets:
Euro sovereign debt
crisis 2010-12
Preceding the current, we saw an expansion both in gross debt and the
cross-border supply of credit, with credit flowing into government finance
and real estate. Countries on the eurozone's periphery – such as Spain,
Greece and Portugal – saw their current account deficits widen. The
economic shock of the global financial crisis boosted the risk premia
required to finance these external imbalances, while individual countries
could not turn to currency devaluation without leaving the eurozone.
WHAT CAN BRING THE ACCOUNTS BACK TO BALANCE?
1Exchange rate: The exchange rate can be used to adjust the relative
competitiveness of a country's exports. By weakening a country's currency,
exports become cheaper while imports become more expensive. This can also
have the effect of making inward investment less attractive.
2Internal prices and demand: In situations where the exchange rate is fixed,
adjustments in domestic prices and demand become more relevant. Governments
have a role to play. They can run sizeable fiscal deficits or surpluses to offset excess
savings, or debt, respectively. Alternatively, market forces may lead to internal
price adjustments within a currency union.
4
5
Figure 3: China balance of payments % GDP1
%
� Current account � Capital account � Errors and omissions
-15
-10
-5
0
5
10
15
Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 Jan 18
Figure 4: China FX reserves (excluding gold)2
Trill
ion
USD
4
3
2
1
0Jan 80 Jan 85 Jan 90 Jan 95 Jan 00 Jan 05 Jan 10 Jan 15 Jan 20
5
1 Source: State Administration of Foreign Exchange (SAFE), January 2020. 2 Source: IMF, April 2020.
CHINA'S BALANCE OF PAYMENTS HAS UNDERGONE A MATERIAL TRANSFORMATION
China's accession to the WTO led to large surpluses
In the late 1990s China maintained a consistent, but small, current
account surplus which was offset by a small capital and capital
account deficit. This all changed in 2001, the year China acceded
to the World Trade Organization (WTO). From this point on China
started to accumulate significant current account surpluses. The
access it gained to new export markets, together with both its
competitive advantage in manufacturing and higher relative
growth rates to its trading partners, led to a significant current
account surplus which peaked at 12% of GDP (Figure 3).
A massive build-up in US Treasury holdings
The surplus that this current account generated needed to be
recycled somewhere. Normally, in the absence of capital controls,
current account surpluses get recycled abroad by the private
sector. However, because China has had capital controls in place,
the only way to prevent the surplus from generating significant
currency appreciation was for the central bank (PBoC) to intervene
in the market and effectively neutralise the surplus.
It did this by selling the renminbi and buying dollars to invest in US
Treasury securities. This trend was clearly seen in the capital
account where there was a significant build up in FX reserves
(US Treasuries) over this period. FX reserves peaked at around
US$4trn in 2013 (Figure 4).
THE PAST CHINA'S BALANCE OF PAYMENTS EVOLUTION CHINA'S BALANCE OF PAYMENTS HAS UNDERGONE A SIGNIFICANT TRANSFORMATION OVER THE LAST TWO
DECADES. A LARGE CURRENT ACCOUNT SURPLUS HAS SHRUNK CONSIDERABLY, CAPITAL OUTFLOWS HAVE
INCREASED, AND CHINA IS NO LONGER A NET RECIPIENT OF FOREIGN DIRECT INVESTMENT FLOWS.
6
THE SURPLUS HAS BEEN DECLINING SINCE 2008
The current account surplus has been in structural decline since 2008, reflecting two key
trends. First, China was growing faster than many of its trading partners and became
increasingly consumer oriented. This formed part of a broader economic trend of the
Chinese economy shifting towards a consumption-led growth model and away from the
export-led growth model it previously followed. Second, in terms of traded goods, following
the initial boost to trade after WTO accession, China started to face export markets in which
it was now the dominant player. With little ability to gain further market share in markets it
had a competitive advantage, China began to see its share of world exports stabilise in 2014
(Figure 5).
Figure 5: Share of world goods and services exports3
China
0
3
6
9
12
15 Germany
Japan
United States
China
Jan 20Jan 16Jan 12Jan 08Jan 04Jan 00Jan 96Jan 92Jan 88Jan 84
%
US Japan Germany
10.7510.34
3.65
7.21
In addition to a declining trade balance, the services balance also became increasingly negative
The services balance also became a larger negative over time, adding additional downward
pressure on the current account. This was largely driven by an increase in outbound
tourism. A US$5bn services surplus in 2008 became a deficit of nearly US$250bn in 2018.
With only 10% of the population estimated to have a passport, there's clearly a lot of scope
for this trend to continue.
3 Source: OECD, January 2020.
The services balance also became a larger negative over time,
adding additional downward pressure on the current account. This was largely driven by an increase in
outbound tourism.
7
INCREASED CAPITAL CONTROLS TO STEM OUTFLOWS
2014-2016: a period of strong capital outflow
China experienced a notable swing from capital inflows to outflows during 2014-2016.
There were several factors driving this. First, international corporates were adjusting their
balance sheets in order to reduce foreign exchange exposure to China. Second, Chinese
corporates and households were seeking to diversify assets offshore at a time when there
was also a renminbi internationalisation push. This facilitated capital outflows by
encouraging outbound investment. Thirdly, these outflows were likely amplified by higher
US interest rates and a stronger US dollar, which proved an attractive draw for capital when
set against what was a weaker outlook for the Chinese economy.
During this period, China ended up using close to US$1trn of its foreign reserves in a bid to
prevent the currency from weakening substantially (Figure 6). Depreciation mitigation was
important to avoid a vicious cycle of even more rapid capital outflows. This period led to
further policy measures to tighten capital controls in a bid to stem the outflow.
Figure 6: USD/CNY exchange rate4
4
6
8
10
Mar 20Mar 15Mar 10Mar 05Mar 00Mar 95Mar 90
Exch
ange
rat
e
NO LONGER A NET RECIPIENT OF FOREIGN DIRECT INVESTMENT
China has been a consistent net recipient of foreign direct investment (FDI) over the past
30 years, typically in the range of 2-4% of GDP (Figure 7). Policymakers began to accelerate
market-oriented reforms and to open markets to foreign capital in 1992. FDI further
accelerated when China joined the WTO in 2001.
As the Chinese macroeconomic environment deteriorated around 2014 FDI inflows began
to slow, while concurrently, FDI outflows picked up. This resulted in net FDI briefly turning
negative in 2016. The push from the Belt and Road Initiative – which we will look at in more
detail later – was one factor contributing to the pickup in FDI outflows, as were concerns
about the domestic growth and near-term currency outlook.
Figure 7: China FDI flows5
% G
DP
Net FDI � inflows � FDI outflows
-4
-2
0
2
4
6
8
Jan 20Jan 18Jan 16Jan 14Jan 12Jan 08 Jan 10Jan 06Jan 04Jan 00 Jan 02Jan 98
3 Source: OECD, January 2020. 4 Source: Bloomberg, April 2020. 5 Source: State Administration of Foreign exchange, January 2020.
8
A PROGRAMME TO CONNECT CHINA WITH MUCH OF THE WORLD
China's Belt and Road Initiative (BRI) (formerly known as One Belt,
One Road) aims to strengthen China's connectivity with the world.
It is an ambitious programme to connect China, with the rest of
Asia, Africa and Europe via land and maritime networks along six
corridors with the aim of improving regional integration,
increasing trade and stimulating economic growth. The name was
coined in 2013 by China's President Xi Jinping, who drew
inspiration from the concept of the Silk Road established during
the Han Dynasty 2,000 years ago – an ancient network of routes
that connected China to the Mediterranean via Eurasia for
centuries.
It has since morphed into a broad catchphrase to describe almost
all aspects of Chinese engagement abroad. It has been dubbed a
‘Chinese Marshall Plan’ by some market commentators. According
to the Asian Development Bank (ADB), Asia faces an infrastructure
funding gap of estimated US$26trn through 2030. The BRI goes
some way to trying to plug this material shortage.
There are five official aims of the BRI:
• Policy coordination
• Infrastructure connectivity
• Unimpeded trade
• Financial integration
• Connecting people
FORMATION AND IMPLEMENTATION
There is no one formal institutional body responsible for the BRI.
Instead, the formation and implementation of the BRI is managed
by a wide range of government agencies, bodies, and committees
from the central government level down to local government
level. There is an overseeing body which sits within the National
Development and Reform commission (NDRC) which oversees
guiding and co-ordinating work related to the initiative.
An important role in implementation is played by the State
International Development Cooperation Agency (SIDCA) which
was formed in April 2018. They are responsible for strategic
guidelines and policies on foreign aid and answer directly to the
State Council. Various other government agencies are also
involved in formulation and implementation of the BRI including
the Ministry of Commerce (MOFCOM), the Ministry of Foreign
Affairs (MOFA) and the Ministry of Culture (MoC). The majority of
provinces in China also have their own local BRI implementation
plans to some degree.
BRI FINANCING
Various funding channels have been utilised to meet the
significant financing needs of the BRI – estimated at over US$1trn.
While BRI bonds, private capital investment and public-private
partnerships all play a role, state-owned enterprises (SOEs) have,
and will continue to have, a crucial role in financing the initiative.
The Belt and Road Initiative is expected to involve over US$1trn in investments – equivalent to 7% of China's
GDP or 1.5% of global GDP
THE PRESENT BELT AND ROAD INITIATIVE THE BELT AND ROAD INITIATIVE AIMS TO STRENGTHEN CHINA'S CONNECTIVITY WITH THE WORLD. IT INVOLVES
VAST FOREIGN DIRECT INVESTMENT OUTFLOWS AND IS EXPECTED TO INVOLVE OVER US$1 TRILLION WORTH OF
INVESTMENT IN COUNTRIES ACROSS ASIA, AFRICA AND EUROPE.
9
SIZE AND SCOPE
The programme is expected to involve over US$1trn in
investments – equivalent to 7% of China’s GDP / 1.5% of global GDP.
There are some differing estimates of how much of this money has
been spent to date, although most centre around the US$250-
350bn mark. The investment has largely been in infrastructure
development for ports, roads, railways and airports, as well as
power plants and telecommunications networks. As of late 2019,
the BRI has reached approximately 138 countries that have a
combined GDP of US$29trn and a population of 4.6bn people.
IS IT CHINA’S MARSHALL PLAN?
The BRI has been called a Chinese Marshall Plan, a state-backed
campaign for a larger role on the global stage, a stimulus package
for a slowing economy, and a massive marketing campaign for
something that was already happening – Chinese investment
around the world. Whilst the BRI and Marshall Plan have many
similarities, particularly in their political-economic objectives, the
economic clout of the BRI is much more significant than the
Marshall Plan was for the US while the structure of the global
economy is very different today compared to after World War II.
If successfully implemented, the BRI could help re-orient a large
part of the world economy toward China. Increasing the amount
of trade, investment, and connectivity between China and
countries throughout Eurasia will also render these countries
more dependent on the Chinese economy, increasing China’s
economic leverage over them in the process. This may empower
China to more readily shape the rules and norms that govern the
economic affairs of the region.
Critics of the BRI are concerned China could use “debt-trap
diplomacy” to extract strategic concessions – such as over
territorial disputes in the South China Sea or silence on human
rights violations. For example, in 2011, China wrote off an
undisclosed debt owed by Tajikistan in exchange for 1,158 square
kilometres of disputed territory.
9
10
CHINA'S CURRENT ACCOUNT LOOKS UNREMARKABLE IN AN INTERNATIONAL CONTEXT
Set in a global context, China’s current account position is unremarkable. The US and the UK
have both run sustainable and gradually increasing current account deficits since the early
1980s. Germany’s current account surplus has strengthened significantly since the
formation of the eurozone in 1997, while Japan has run a structural current account surplus
of around 1% to 3% of GDP since 1980. China lies somewhere in the middle of the pack
globally, with a current account that is close to balanced. But it has undergone one of the
largest current account transformations over the last 10 years (Figure 8).
Figure 8: Selected current accounted balances6
-6-4-202468
1012 UK
Germany
Japan
US
China
Mar 20Mar 15Mar 10Mar 05Mar 00Mar 95Mar 90Mar 85Jun 80
% G
DP
China US Japan Germany UK
THE PRESENT CHINA’S EXTERNAL BALANCES: UNREMARKABLE ON INTERNATIONAL COMPARISON CHINA'S EXTERNAL BALANCES APPEAR RELATIVELY UNREMARKABLE
WHEN COMPARED WITH THOSE FOR OTHER MAJOR ECONOMIES. ITS
CURRENT ACCOUNT POSITION IS BALANCED, AND WHILE IT IS A NET
ACCUMULATOR OF FOREIGN ASSETS, ITS EARNINGS FROM NET FOREIGN
INCOME IS NEGATIVE.
6 Source: IMF, April 2020.
China's current account position is unremarkable in an international context.
However, it has undergone a significant transformation
11
6 Source: IMF, April 2020.
CHINA IS A NET ACCUMULATOR OF FOREIGN ASSETS, WHILE THE US IS A BORROWER
In recent years, China's accumulation of foreign assets has been the subject of increasing
public attention. While China has accumulated a material amount of net foreign assets since
2000, it is no more so than the likes of Germany and Japan, who both have much smaller
economies and populations (Figure 9).
The US meanwhile has shifted from being the world's largest creditor to the world's largest
debtor. Until the 1980s the US held 2% of global GDP in foreign assets, now they owe more
than US$4trn to the rest of the world. Persistent current account deficits have meant the US
has to borrow from the rest of the world to finance domestic consumption.
Figure 9: Net foreign assets7
-8-6-4-20246 UK
Germany
Japan
USA
China
201020001990198019701960
% gl
obal
GD
P
China US Japan Germany UK
YET THE US' NET INCOME POSITION IS POSITIVE WHILE CHINA'S IS NEGATIVE
Net foreign income tells a very different story however. The US actually comes out best on
this metric whereas China has the weakest position. This is a function of the asset
composition that each country has. China predominately owns low-yielding US Treasuries,
while its liabilities in the form of FDI inflows, generate larger income flows for developed
economies such as the US. The US is the reverse of this position, its liabilities being chiefly
low-yielding US Treasuries funding higher-yielding outwards FDI.
Figure 10: Net foreign income8
-0.15-0.10-0.050.000.050.100.150.200.250.300.35 UK
Germany
Japan
USA
China
201020001990198019701960
% gl
obal
GD
P
China US Japan Germany UK
7,8 Source: IMF, April 2020.
12
THE FUTURE CHINA'S EXTERNAL BALANCES TRAJECTORYIN THIS SECTION WE OUTLINE OUR EXPECTATIONS FOR THE TRAJECTORY
OF CHINA'S CURRENT ACCOUNT BALANCE, INCOME BALANCES,
PORTFOLIO FLOWS AND NET FOREIGN DIRECT INVESTMENT.
CURRENT ACCOUNT BALANCE
We expect gradual decline
Under our base case, we expect China's goods balance to remain positive but to
continue gradually declining, in part due to China's saturated export market share. With
China's growth rate continuing to outpace key trading partners, we expect imports to
increase at a faster rate than exports. On the services side, we expect the balance to
become increasingly negative due to outbound tourism.
Risks to this base case are two-fold, in our view. First, if China successfully moves up
the value chain it could regain and / or increase market export share in new
industries. Second, if global trade tensions re-escalate and there is a further relocation of
production chains outside of China, the goods trade balance may deteriorate quicker than
we expect.
INCOME BALANCES
Income balances should remain broadly neutral
We expect the primary and secondary income balances to remain broadly neutral
and inconsequential to the current account given its small relative size to the goods and
services trade balances.
There is a risk that it may move in a negative direction given that the composition of
the external income is made up largely of US Treasuries and is lower than the
Chinese interest rate structure.
PORTFOLIO FLOWS
We expect portfolio inflows to increase
Historically, portfolio flows have been a relatively insignificant part of China’s
external balances due to significant capital flow restrictions. This is in the process of
changing however, a shift that will likely only accelerate as support from the current account
ebbs away. China is likely to have a greater requirement for external financing going
forwards given the ongoing structural deterioration of the current account.
PORTFOLIO OUTFLOWS
Chinese investors have a significant home bias and an unbalanced asset allocation. If
restrictions to capital outflows are eased, a significant amount of outflow could potentially
take place. There are questions over the timing size of such outflows. This is one of the key
components for the direction of both the balance of payments and the Chinese renminbi.
13
PORTFOLIO INFLOWS
Bond and equity index inclusion to drive inflows
Index inclusion has been a key driver of inflows. Chinese government and policy bank bonds
entered the Bloomberg Barclays Global Aggregate Index in April 2019, the JPMorgan GBI-EM
indices in March 2020 and are likely to enter Citi's WGB Index in the next 12 to 18 months.
Index inclusion across these three indices would total around US$250-300bn (c.2% of GDP)
over the next 2-3 years with room to grow if China's weight was increased further over time.
On the equities side, Chinese equities account for c.12% of the global equity market
capitalisation yet only account for c.0.25% of global equity funds holdings due to a
combination of exchange controls and other restrictions. The launch of the Stock Connect
programme and future inclusion in global equity indices could lead to inflows of c.US$100-
200bn per annum.
The renminbi as a reserve currency
Whether or not the renminbi can become a genuine reserve currency is probably the key
swing factor in determining the annual pace of net portfolio inflows over the next decade.
Global FX reserves, ex-China, currently stand at US$8.2trn with the renminbi representing
just 2.5% of this. This compares against China's 15% share of global GDP, 11.9% share in
global trade and its 10.9% weight in the IMF's special drawing rights (SDR) basket of reserve
currencies. It is a clear aim of policymakers to further expand the renminbi's role in the
global financial system, and it seems feasible that the renminbi's weight in global reserves
could increase towards 5-10% over the next decade. This would translate to c.US$50bn-
US$100bn in capital inflows per annum.
Among the key risks to this outlook include firstly, whether bond and equity indices
proceed with the inclusion of Chinese assets to the extent that we expect or not.
Secondly, if China fails to establish the renminbi as a genuine reserve currency, we are
unlikely to see its current weight change in global reserve portfolios. Lastly, if China relaxes
outbound capital controls sooner than expected there is a chance of renewed capital flight
as investors seek to diversify their portfolios.
NET FOREIGN DIRECT INVESTMENT
China's net FDI position to remain largely unchanged
We expect China's net FDI position to continue to deteriorate but remain broadly
neutral in terms of its contribution to the capital account. We could potentially see a small
drift negative as inward FDI slows further and China diversifies production abroad. We
expect policymakers to continue to expand market access, remove ownership limits and
further improve intellectual property rights protection for foreign entities. China will likely
maintain key competitive advantages in sectors in which it is the dominant player.
Furthermore, we expect China to continue to move up the value chain in global
manufacturing and continue to be a rising innovative power in hi-tech industries.
There is plenty of scope for outbound FDI to expand. Cumulative outward direct investment
to GDP currently stands at 12% which is significantly below the G3 average of 64%.
There are a few risks to this view. A further escalation of trade tensions between the
US and China could lead to a shift in FDI away from China to other markets in the
region. Additionally, if Chinese policymakers change tact and decide not to move
forward with plans to expand market access to foreign entities, we could see a reduction in
inbound FDI.
THE FUTURE POLICY AND INVESTMENT IMPLICATIONSEXTERNAL BALANCES FORECAST
Our base case is for China's current account to move from surplus
to deficit in the next 2-3 years. We expect the current account to
remain in negative territory in the medium term. We do not expect
this to prove difficult to finance without challenging financial
stability since:
1There is a strong external balance sheet (net foreign
assets) including a large quantity of liquid reserves
2Structural portfolio inflows on capital account to help
financing
3Low level of external debt, most of which is domestically
financed
4China has demonstrated an ability to move up the value
chain to help buffer the drag on the trade balance from
transitioning to a consumption-led growth model
POLICY IMPLICATIONS
The ‘impossible trinity’ is the idea that an economy can’t have
these three things at the same time: a fixed exchange rate, an
open capital account and independent monetary policy. In the
past China has claimed that it has successfully conquered the
impossible trinity, but in reality it has essentially staggered
between the three pillars. In 2005, the dollar peg was abandoned
in pursuit of a ‘managed float’ which has evolved several times
since. When the PBoC lost control of the managed float they took
firmer control of the exchange rate. However, the result was
informal lenders taking control of setting domestic interest rates.
The impossible trinity
Open capitalaccount
Fixedexchange
rate
Independentmonetarypolicy
In mid-2016 capital controls were tightened to help stem currency
weakness and have not been loosened much since. With China
opening its financial sector to global markets, this policy trade-off
is going to continue to get more difficult to manage. It seems likely
that the capital account will need to be relaxed further as China
integrates further into the global financial system and for the
renminbi to become a genuine reserve currency. This will
necessitate a reduction in influence on the level of the currency or
interest rates over time.
CURRENCY IMPLICATIONS
The deterioration in the current account into negative territory is
usually associated with a declining currency, but there are a few
idiosyncrasies that suggest that renminbi stability is more likely in
the short term:
• The current account deterioration is likely to be both gradual
and moderate
• Capital inflows from index inclusion should easily finance it
• As part of the drive to internationalise the currency, authorities
have a strong incentive to maintain a stable renminbi and have
the tools to deliver it
There are longer-term risks skewed to the downside. While capital
inflows are being liberalized at a reasonable pace – as highlighted
by index inclusions and greater accessibility to domestic
investment by corporates – the restrictions to capital outflows are
still notable. It is estimated that Chinese household net wealth is
roughly US$29trn and it is invested predominantly in real estate
and local financial assets. Therefore, a 1% reduction in home bias
could generate as much as US$289 of capital outflows – this is
more than double the size of the current account surplus.
Our base case is for the renminbi to remain stable during the
period of capital inflow liberalisation (next 1-2 years). Beyond that,
the outlook is more challenging as pressure will likely build on the
Chinese leadership to increase the liberalisation of capital
outflows.
BOND AND EQUITY MARKET IMPLICATIONS
We think that Chinese government bonds should benefit from the
positive technical of broader index inclusion over the next 2-3
years. Foreign ownership has significant room to increase beyond
the benchmark weight levels. This is one supportive factor in our
medium-term view to be long Chinese rates relative to other
markets. Chinese corporate bonds should eventually follow the
same route as government bonds for index inclusion and
increasing foreign ownership.
Chinese equities should also enjoy support from the technical of
index inclusion. However, this must be weighed against any
potential negative impact from a loosening of capital controls if
domestic investors choose to meaningfully diversify their equity
exposures.
IMPORTANT INFORMATION
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document must not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or otherwise not permitted. This document should not be duplicated, amended or forwarded to a third party without consent from Insight Investment.
This material may contain ‘forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass.
Past performance is not indicative of future results.
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
Index returns are for illustrative purposes only and do not represent any actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.
Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment.
References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice.
The information and opinions are derived from proprietary and non-proprietary sources deemed by Insight Investment to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Insight Investment, its officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader.
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Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number 00827982. Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number 119308.
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CONTRIBUTORS
Harvey Bradley, Portfolio Manager, Fixed income Insight Investment
Derek Traynor, CFA Senior Investment Content Specialist Insight Investment
Francesca Fornasari, Head of Currency Solutions, Currency Management Group, Insight Investment
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