Stress-testing our constructive renminbi view

Risk no.1: Deterioration in export outlook and worsening US-China trade dialogue

US-China tensions have been in train for a long time, and concern several areas relating to trade practices, technology, human rights issues, and Chinese aggression towards neighbours like Taiwan and Hong Kong. These tensions will no doubt remain in place. However, the area of tensions that undermined the RMB in the past was clearly a ratcheting up in trade tensions after 2018 and, in particular, an escalation in tariff-related barriers.

While the US-China relationship under President Biden could retain its complex character in several areas, we assign a low chance to an escalation in trade tensions. It is plausible that the Section 301 trade tariffs will remain in place for longer (against our 50% assigned probability of some tariff reduction in the next 12-18 months). However, besides the level of tariffs themselves, the export outlook matters more for the renminbi.

When we review the two most recent periods when the RMB began a depreciation trend, 2015 and 2018, the common denominator is a worsening picture for exports. Back in 2015, both the Chinese (and global) trade picture was worsening at a fast pace in the context of a currency that was clearly overvalued (at the time, USDRMB stood below 6.40 through 2014-15 even as EURUSD fell all the way from 1.40 to under 1.10). In 2018, it was the imposition of tariffs by the US administration against an already soft outlook for exports. In 2018, the imposition of tariffs resulted in increased uncertainty and hit Chinese exports. That coincided with depreciation pressure on the currency.

Fast forward to today, the outlook for Chinese (and global) exports appears better. The most recent April trade data showed a continued growth rate above 30% YoY, despite tougher base effects, and an improving trend in exports of goods leveraged to the global manufacturing cycle, such as capital and consumer goods and intermediate products. That was despite a strong decline in demand for goods that had performed well because of the Covid situation (electronics, personal protection equipment, etc.) noted earlier. Similarly, several other Asian countries (to which China is linked via supply chains and exports are correlated) were also showing healthy levels export growth. For reference, the Asian manufacturing PMI new export orders component now stands above the 80th percentile of its history (vis-à-vis 50th percentile in both 2015 and 2018). While we will continue to monitor the export outlook for risks to our view, so far things still appear relatively sanguine.

Risk no.2: Sharp weakening in property sector and a brisk pace of credit tightening

We think the Chinese activity data, the property sector in particular, and the authorities’ stance on credit would need to be monitored. Back in 2013-14, a strong loosening in monetary policy followed by tightening led to a sharp weakening in the property sector. That contributed to large capital outflows from domestic residents, and resultant renminbi depreciation pressure. Currently, while the authorities are taking targeted macro-prudential measures to slow the pace of lending, property sector data has remained relatively resilient. Consensus growth expectations for China stand in the ballpark of 8.5% for 2021 and our own view is a touch more positive (we forecast 9% for 2021). Credit is being tightened via quantitative measures, such as restrictions on lending, as well as reduced local government bond issuance. However, compared to past episodes when China was seen as moving from periods of overstimulation on to overtightening, the credit cycle this time around remains somewhat more calibrated.

Risk no.3: Authorities allow RMB depreciation to accommodate rising geopolitical tensions

Some observers have suggested that Chinese authorities could weaken the currency, or simply “let it go” in certain unforeseen circumstances, such as a China-Taiwan war, or a domestic incident (such as the recent near-default of a state-owned asset management company). While nothing can be ruled out, we believe the image of a central bank “letting the currency go” brings back images of China’s so called mini-devaluation (Q3 2015), or of Russia letting go of the rouble in late 2014. However, at the starting point of all those instances, currency fundamentals pointed to depreciation pressures for the currency. Either balance of payments pressures were weakening sharply, or there was a drastic change in the FX regime. In 2015, both these factors came together to deliver a renminbi depreciation.

This time around, however, the balance of payments remains quite strong. The current account is expected to remain comfortably in surplus, though the recent strength could wane somewhat as the Covid situation normalises and Chinese outbound tourism resumes. On the capital flows front, stable portfolio inflows into the debt market are expected from benchmarked investors (estimates point to USD 150 bn inflows). These flows will be structural and less sensitive to global risk appetite. Finally, despite the willingness of China`s State Council to tolerate higher defaults (or re-structuring) of state-owned enterprises), most of Chinese corporate debt is locally financed in the renminbi (and less so via foreign currency). This should imply a lower risk to the currency compared to other emerging market countries.

If anything, we would still argue that the risk is skewed towards China allowing for a faster pace of appreciation than that already seen. The new US administration appears to have sharpened its focus on the lack of transparency on Chinese FX intervention activities given tentative evidence of USD accumulation by state-owned Chinese banks and other local players. Assuming that the dialogue on the trade side between the US and China continues, and the outlook for Chinese exports remains decent, we believe there is a good chance that authorities will be pressured to accommodate a stronger RMB in the quarters ahead.

Risk no.4: A sizeable increase in outbound investments from Chinese residents

Since 2015 authorities have worked harder to reduce the barrier of entry for capital inflows (from foreign investors), but have been relatively conservative on allowing exit of capital outflows (from domestic residents). This asymmetric treatment of the capital account (allowing inflows, but not outflows) has contributed to reducing excessive depreciation pressures after 2016. However, in recent quarters, authorities have been gradually loosening these screws. Our assumption is that the pace of outbound investments from Chinese residents will be managed gradually, but we will continue to track these developments.

In sum, we remain constructive on the renminbi given the supportive valuation, strong balance of payments support, and a still-decent outlook for Chinese exports. We continue to hold an overweight via the long Chinese government debt holding. The common denominator of weaker global export outlook, seen in both the 2015 and 2018 episodes of RMB depreciation, are not present at this stage. That said, we would continue to monitor the China-US trade agenda and export outlook, the domestic growth cycle, and authorities’ liberalisation of capital outflows going forward.

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