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Why is the Chinese yuan(CNY) trading weak recently? Since the middle of September, USDCNY has traded fairly consistently below the morning fixing. It has tested the weak end of the daily +/0.5% band five times to date, and generally in the last two weeks the CNY has ended the day with no offer. Chart 1 shows the percentage difference between the day-end USD-CNY price to the fix (we use the 5-day moving average to smooth out some of the volatility). This price action suggests that the market is not selling US dollars (USD) as it once did and that the People’s Bank of China(PBoC) could be selling USD from its FX revenues. The FX reserves fell in September and initial indications for October suggest that this trend has continued. With China still running a sizeable trade surplus (USD 17bn in October), some suggest that CNY weakness could be evidence that ‘hot money’ is leaving the country. The recent falls in bank deposits have added to this view.
In contrast, we believe that CNY weakness is being driven by importers and exporters changing their FX conversion and payment behaviour, rather than by capital account transactions or by, ‘hot’ money outflows.
Trading companies’ conversion decisions are critical
The key to this puzzle is realising that exporters do not sell all their USD receipts, and importers do not buy all of their USD needs. In addition, the amounts that they buy and sell, relative to their trading needs, vary over time. Such shifts in behaviour are in part driven by appreciation expectations, but this is normal everywhere in the world. Because China’s companies conduct huge amounts of trade, small changes in their behaviour can have big impacts in the onshore interbank FX market.
Chart 2 shows the behaviour of China’s export and import companies in terms of how they have dealt with their foreign currency needs over time.
* Exporters. Before China’s exchange rate reform in July 2005, exporters tended to sell 50-60% of their FX receipts. Then, after CNY appreciation expectations kicked in, they began to sell 60-80%, and holding USD became a losing game, given the depreciation of the dollar. We assume that they did not sell 100% of their FX receipts since they needed some foreign currency to buy materials and components from overseas. Remember that 44% of total exports are currently classified as ‘processing’ for tax reasons, and thus involve the simultaneous import and export of goods.
Faster CNY appreciation expectations since 2007 pushed exporters to sell more USD (and also to sell USD forward in the onshore deliverable market, on which more below). The export conversion ratio against the expected appreciation implied in the offshore 12m non-deliverable forward (NDF) market. We find that both the conversion ratio and the 12m NDF moved up sharply at the end of 2008. We also find that the conversion ratio moved up again in H1-2011, despite much more limited appreciation expectations in the NDFs.
* Importers. Thanks to CNY appreciation expectations, importers have had the opposite incentive – they want to delay before buying any foreign currency they need. They are even better served by borrowing USD from the bank rather than buying it. As we explained earlier this year, during 2009-10, banks issued USD 140bn worth of USD loans. So, as Chart 2 shows, before the 2008 crisis, importers only bought FX equivalent to 40-5% of their payment needs (at which time 30-40% of imports were being handled by ‘processing’ firms).
However, during the crisis in late 2008, importers’ behaviour changed dramatically. Suddenly they were buying much more FX – 90% of their needs, at one point. This was thanks to a big reversal in CNY appreciation expectations– indeed, expectations shifted to CNY depreciation at the end of 2008. Importers suddenly wanted their USD quickly, and likely also needed USD to cover short USD positions taken in the forwards (remember that many companies are both importing and exporting, and run their FX book taking both sides into account).
CNY appreciation expectations have fallen again, and some in the market even look for CNY depreciation. Importers are now buying more USD again. Importers’behaviour is also affected by the new offshore CNH market.
How much of an effect does export and import companies’ conversion behaviour have on the amount of (net) USD-selling by China’s corporate sector? The impact is substantial. Chart 3 shows the difference between the monthly trade surplus and the net amount of FX sold by the corporates who import and export. ‘Surplus’ USD selling has averaged USD 8bn a month since exchange rate reform in July 2005. In the first six months of 2011, it averaged USD 28bn a month. From July to October, the monthly average dropped to USD 2bn. Not only can the flows be large, but they are also volatile.
Any shift in the FX buying and selling behaviour of China’s huge tradables sector can have a major impact on overall USD demand in the interbank market. We note, too, that the ‘surplus’ USD selling by the corporate sector in H1-2011 was even bigger than in H2-2010, when CNY appreciation expectations were running high.
Clearly, the scale and timing of these transactions are strongly related to CNY appreciation expectations. Chart 4 shows the ‘surplus’ USD selling by the tradables sector against appreciation expectations in the 12m NDF. Expectations have historically led behaviour by a month or two.
This relationship held until 2010-11. But we have seen much more significant USD selling onshore this year than the 12m NDF implies. We believe that this is partly explained by the creation of the offshore CNH market and the emergence of a CNH premium in H1-2011 (USD-CNH traded below USD-CNY), which encouraged importers (who are USD buyers onshore) to move their spot transactions offshore in H1-2011. This move led to much bigger net USD selling offshore than otherwise would have been the case – and helps explain some, though not all, of the surge seen in H1-2011 (Chart 3). The CNH market, though, is only part of the reason.
In mid-September, just when USD-CNY began to trade weaker onshore, the CNH moved sharply into discount, and it was at this point that exporters, rather than importers, had a big incentive to sell their USD offshore rather than onshore. Suddenly, exporters onshore stopped selling their USD to the banks, and importers suddenly started buying more, the results of which we show in Chart 5.
The result: almost zero USD selling from the corporate sector to the banks in late September, October and early November, and onshore appreciation pressure apparently disappeared. On many days during this period, the market saw net USD buying, meaning that USD-CNY weakened off the fix, as seen in Chart 1, and FX reserves fell, as they did in September.
Capital account transactions are important, but current account dominates
It is also well worth looking at the FX transaction behaviour of companies doing capital account-type transactions, which include fixed investment, securities investment and other types of investment that are carried out through the banks. In Chart 6, we show net USD selling by companies doing such transactions against the implied appreciation of the 12m NDF. There is a relatively strong correlation between the two. We find that most of the change is driven by the ebbs and flows of corporate USD sellers (CNY buyers), while the corporate USD buying flow (Chinese investors going overseas, for instance) is smaller and fairly steady. This was certainly the case in October, for example. In other words, capital account outflows are not the cause of recent CNY weakness.
However, all that said, it is important to note that the dominant flow of USD sales through the banks (and usually into the PBoC) is through the current account, rather than the capital account. Chart 7 shows the net USD selling flows from corporates for current and capital account transactions.
What this all means for China’s FX reserves
China’s FX reserves fell in September, 2011 by USD 61bn, as can be seen in Chart 8. However, the data that we have examined today suggests that this was not the result of FX outflows. Net FX sales from the corporate sector in September were positive (USD 26bn). Net FX purchases in September were also strongly positive, at USD 59bn.
One hypothesis for the fall in the FX reserves is that the FX reserve portfolio was marked to market, both in terms of FX valuations (some- thing we have long assumed the State Administration of Foreign Exchange does) and for the portfolio. European bonds began to fall in September, and could have generated a book loss. That said, German bund prices strengthened, and we suspect China’s euro portfolio is dominated by bunds, so this issue needs further investigation.
The apparent FX reserve loss in September was around USD 90bn, given the apparent net inflow of around USD 59bn (net FX purchases), and we estimate the FX valuation-adjusted fall at USD 30bn. Last October and November saw continued stress in the nonGerman sovereign market, and so we could see more losses booked, perhaps at the end of Q4, 2011. At the same time, the dynamics we have examined in this note suggest that new FX inflows from the corporate sector and the banks will decline too, regardless of what is happening with the trade surplus. Thus, we look for official reserves to end the year at their present level of USD 3.2trn, or lower.
What this all means for tracking FX reserve accumulation
This leads us to two big lessons about how the market should track China’s FX reserve accumulation. The traditional method has been to subtract the trade surplus, FDI and interest paid on FX reserves from the FX reserve number to calculate ‘hot’ inflows. However, we have showed clearly today that the trade surplus is a very inaccurate way of assessing the FX behaviour of the corporate sector. Moreover, we have also argued that the banks’ own FX positions are potentially also very significant. Thus, the market is continually exaggerating the scale of ‘hot’ inflows.
Nonetheless, there is a debate to be had about how to characterise the strategic behaviour of corporates and banks. It is not really about ‘hot’ money – big bad portfolio inflows that wash in and out of a country (and there is an underlying belief in some parts of China that that is what is happening) – and, crucially, all of the activity we have discussed today is legal. But this behaviour plainly also involves the corporates and banks taking advantage of CNY appreciation expectations, taking long CNY/short USD positions, and forcing the PBoC to take the opposing side of the trade. Moreover, as we are now seeing, these transactions can slow or even be reversed, causing FX reserves to fall.
The 2012 CNY-USD outlook: the PBoC and market forces
Events in recent months have underlined the PBoC’s ability to set the daily fix without taking into account the balance of demand and supply in the onshore USD-CNY market. The daily USD-CNY fix has been lower (CNY stronger) following days on which the CNY ended on-shore trading at the weak end of the trading limit (and without an active USD-CNY market offer). In the battle between market forces and PBoC, the central bank is currently winning, preventing further CNY weakness. As such, over the coming weeks and months, market forces may well allow the PBoC to step back and allow greater two-way variability.
Our analysis suggests that swings in net USD demand onshore primarily reflect shifts in corporate appetite for conversion, rather than capital account flows. Will the diminished net USD supply evident in 2011 persist into H1-2012? China’s trade performance tends to be less robust in the early months of the year, which will affect appreciation sentiment. Moreover, the weakness of the major developed economies(particularly the euro zone) will foster risk aversion in global financial markets and could drive the USD higher against other Asia ex-Japan currencies. Against this backdrop, it would be most unlikely that expectations for CNY appreciation would rebound significantly.
Indeed, onshore corporates may even be willing to further scale back the pace of conversion of USD receivables back into CNY. This could lead to falls in the FX reserves in H1-2012. Moreover, to the extent that the demand and supply for USD are roughly in balance in H1-2012, China may well be able to give a bigger role to market forces in driving the CNY’s valuation.
Faltering global economic growth externally and a substantial easing in inflationary pressures domestically have eroded the case for significant CNY gains over the next few quarters. Any net CNY advance against the USD will likely be very modest and hard won, as the USD-CNY cross displays substantially more ‘two-way variability’ than we have seen in 2011.
If global growth prospects improve later in 2012 and exports pick up, a clearer CNY appreciation path is then likely to re-emerge (we project 1% quarter-by-quarter gains later in 2012 and into 2013). At that point, a pick-up in USD selling on-shore from China’s corporate sector and a rebound in CNY appreciation expectations would be just a small symptom of a much broader global economic recovery dynamic.
(Authors: from Standard Chartered Bank China)
In contrast, we believe that CNY weakness is being driven by importers and exporters changing their FX conversion and payment behaviour, rather than by capital account transactions or by, ‘hot’ money outflows.
Trading companies’ conversion decisions are critical
The key to this puzzle is realising that exporters do not sell all their USD receipts, and importers do not buy all of their USD needs. In addition, the amounts that they buy and sell, relative to their trading needs, vary over time. Such shifts in behaviour are in part driven by appreciation expectations, but this is normal everywhere in the world. Because China’s companies conduct huge amounts of trade, small changes in their behaviour can have big impacts in the onshore interbank FX market.
Chart 2 shows the behaviour of China’s export and import companies in terms of how they have dealt with their foreign currency needs over time.
* Exporters. Before China’s exchange rate reform in July 2005, exporters tended to sell 50-60% of their FX receipts. Then, after CNY appreciation expectations kicked in, they began to sell 60-80%, and holding USD became a losing game, given the depreciation of the dollar. We assume that they did not sell 100% of their FX receipts since they needed some foreign currency to buy materials and components from overseas. Remember that 44% of total exports are currently classified as ‘processing’ for tax reasons, and thus involve the simultaneous import and export of goods.
Faster CNY appreciation expectations since 2007 pushed exporters to sell more USD (and also to sell USD forward in the onshore deliverable market, on which more below). The export conversion ratio against the expected appreciation implied in the offshore 12m non-deliverable forward (NDF) market. We find that both the conversion ratio and the 12m NDF moved up sharply at the end of 2008. We also find that the conversion ratio moved up again in H1-2011, despite much more limited appreciation expectations in the NDFs.
* Importers. Thanks to CNY appreciation expectations, importers have had the opposite incentive – they want to delay before buying any foreign currency they need. They are even better served by borrowing USD from the bank rather than buying it. As we explained earlier this year, during 2009-10, banks issued USD 140bn worth of USD loans. So, as Chart 2 shows, before the 2008 crisis, importers only bought FX equivalent to 40-5% of their payment needs (at which time 30-40% of imports were being handled by ‘processing’ firms).
However, during the crisis in late 2008, importers’ behaviour changed dramatically. Suddenly they were buying much more FX – 90% of their needs, at one point. This was thanks to a big reversal in CNY appreciation expectations– indeed, expectations shifted to CNY depreciation at the end of 2008. Importers suddenly wanted their USD quickly, and likely also needed USD to cover short USD positions taken in the forwards (remember that many companies are both importing and exporting, and run their FX book taking both sides into account).
CNY appreciation expectations have fallen again, and some in the market even look for CNY depreciation. Importers are now buying more USD again. Importers’behaviour is also affected by the new offshore CNH market.
How much of an effect does export and import companies’ conversion behaviour have on the amount of (net) USD-selling by China’s corporate sector? The impact is substantial. Chart 3 shows the difference between the monthly trade surplus and the net amount of FX sold by the corporates who import and export. ‘Surplus’ USD selling has averaged USD 8bn a month since exchange rate reform in July 2005. In the first six months of 2011, it averaged USD 28bn a month. From July to October, the monthly average dropped to USD 2bn. Not only can the flows be large, but they are also volatile.
Any shift in the FX buying and selling behaviour of China’s huge tradables sector can have a major impact on overall USD demand in the interbank market. We note, too, that the ‘surplus’ USD selling by the corporate sector in H1-2011 was even bigger than in H2-2010, when CNY appreciation expectations were running high.
Clearly, the scale and timing of these transactions are strongly related to CNY appreciation expectations. Chart 4 shows the ‘surplus’ USD selling by the tradables sector against appreciation expectations in the 12m NDF. Expectations have historically led behaviour by a month or two.
This relationship held until 2010-11. But we have seen much more significant USD selling onshore this year than the 12m NDF implies. We believe that this is partly explained by the creation of the offshore CNH market and the emergence of a CNH premium in H1-2011 (USD-CNH traded below USD-CNY), which encouraged importers (who are USD buyers onshore) to move their spot transactions offshore in H1-2011. This move led to much bigger net USD selling offshore than otherwise would have been the case – and helps explain some, though not all, of the surge seen in H1-2011 (Chart 3). The CNH market, though, is only part of the reason.
In mid-September, just when USD-CNY began to trade weaker onshore, the CNH moved sharply into discount, and it was at this point that exporters, rather than importers, had a big incentive to sell their USD offshore rather than onshore. Suddenly, exporters onshore stopped selling their USD to the banks, and importers suddenly started buying more, the results of which we show in Chart 5.
The result: almost zero USD selling from the corporate sector to the banks in late September, October and early November, and onshore appreciation pressure apparently disappeared. On many days during this period, the market saw net USD buying, meaning that USD-CNY weakened off the fix, as seen in Chart 1, and FX reserves fell, as they did in September.
Capital account transactions are important, but current account dominates
It is also well worth looking at the FX transaction behaviour of companies doing capital account-type transactions, which include fixed investment, securities investment and other types of investment that are carried out through the banks. In Chart 6, we show net USD selling by companies doing such transactions against the implied appreciation of the 12m NDF. There is a relatively strong correlation between the two. We find that most of the change is driven by the ebbs and flows of corporate USD sellers (CNY buyers), while the corporate USD buying flow (Chinese investors going overseas, for instance) is smaller and fairly steady. This was certainly the case in October, for example. In other words, capital account outflows are not the cause of recent CNY weakness.
However, all that said, it is important to note that the dominant flow of USD sales through the banks (and usually into the PBoC) is through the current account, rather than the capital account. Chart 7 shows the net USD selling flows from corporates for current and capital account transactions.
What this all means for China’s FX reserves
China’s FX reserves fell in September, 2011 by USD 61bn, as can be seen in Chart 8. However, the data that we have examined today suggests that this was not the result of FX outflows. Net FX sales from the corporate sector in September were positive (USD 26bn). Net FX purchases in September were also strongly positive, at USD 59bn.
One hypothesis for the fall in the FX reserves is that the FX reserve portfolio was marked to market, both in terms of FX valuations (some- thing we have long assumed the State Administration of Foreign Exchange does) and for the portfolio. European bonds began to fall in September, and could have generated a book loss. That said, German bund prices strengthened, and we suspect China’s euro portfolio is dominated by bunds, so this issue needs further investigation.
The apparent FX reserve loss in September was around USD 90bn, given the apparent net inflow of around USD 59bn (net FX purchases), and we estimate the FX valuation-adjusted fall at USD 30bn. Last October and November saw continued stress in the nonGerman sovereign market, and so we could see more losses booked, perhaps at the end of Q4, 2011. At the same time, the dynamics we have examined in this note suggest that new FX inflows from the corporate sector and the banks will decline too, regardless of what is happening with the trade surplus. Thus, we look for official reserves to end the year at their present level of USD 3.2trn, or lower.
What this all means for tracking FX reserve accumulation
This leads us to two big lessons about how the market should track China’s FX reserve accumulation. The traditional method has been to subtract the trade surplus, FDI and interest paid on FX reserves from the FX reserve number to calculate ‘hot’ inflows. However, we have showed clearly today that the trade surplus is a very inaccurate way of assessing the FX behaviour of the corporate sector. Moreover, we have also argued that the banks’ own FX positions are potentially also very significant. Thus, the market is continually exaggerating the scale of ‘hot’ inflows.
Nonetheless, there is a debate to be had about how to characterise the strategic behaviour of corporates and banks. It is not really about ‘hot’ money – big bad portfolio inflows that wash in and out of a country (and there is an underlying belief in some parts of China that that is what is happening) – and, crucially, all of the activity we have discussed today is legal. But this behaviour plainly also involves the corporates and banks taking advantage of CNY appreciation expectations, taking long CNY/short USD positions, and forcing the PBoC to take the opposing side of the trade. Moreover, as we are now seeing, these transactions can slow or even be reversed, causing FX reserves to fall.
The 2012 CNY-USD outlook: the PBoC and market forces
Events in recent months have underlined the PBoC’s ability to set the daily fix without taking into account the balance of demand and supply in the onshore USD-CNY market. The daily USD-CNY fix has been lower (CNY stronger) following days on which the CNY ended on-shore trading at the weak end of the trading limit (and without an active USD-CNY market offer). In the battle between market forces and PBoC, the central bank is currently winning, preventing further CNY weakness. As such, over the coming weeks and months, market forces may well allow the PBoC to step back and allow greater two-way variability.
Our analysis suggests that swings in net USD demand onshore primarily reflect shifts in corporate appetite for conversion, rather than capital account flows. Will the diminished net USD supply evident in 2011 persist into H1-2012? China’s trade performance tends to be less robust in the early months of the year, which will affect appreciation sentiment. Moreover, the weakness of the major developed economies(particularly the euro zone) will foster risk aversion in global financial markets and could drive the USD higher against other Asia ex-Japan currencies. Against this backdrop, it would be most unlikely that expectations for CNY appreciation would rebound significantly.
Indeed, onshore corporates may even be willing to further scale back the pace of conversion of USD receivables back into CNY. This could lead to falls in the FX reserves in H1-2012. Moreover, to the extent that the demand and supply for USD are roughly in balance in H1-2012, China may well be able to give a bigger role to market forces in driving the CNY’s valuation.
Faltering global economic growth externally and a substantial easing in inflationary pressures domestically have eroded the case for significant CNY gains over the next few quarters. Any net CNY advance against the USD will likely be very modest and hard won, as the USD-CNY cross displays substantially more ‘two-way variability’ than we have seen in 2011.
If global growth prospects improve later in 2012 and exports pick up, a clearer CNY appreciation path is then likely to re-emerge (we project 1% quarter-by-quarter gains later in 2012 and into 2013). At that point, a pick-up in USD selling on-shore from China’s corporate sector and a rebound in CNY appreciation expectations would be just a small symptom of a much broader global economic recovery dynamic.
(Authors: from Standard Chartered Bank China)