CHINA

7th Jan. 2016

ECONOMICS UPDATE
How long can the PBOC hold on?
• The willingness of the People’s Bank to sell over $100bn of foreign exchange reserves last month is a
measure of its belief that a stable currency is in China’s interests and that current downward pressure
is driven by speculative rather than fundamental forces. It will have to continue to intervene on a large
scale in the short term to shift market perceptions that the renminbi is a one-way bet but given the
still-high level of reserves it can do so for a long time yet.
• We estimate that the People’s Bank sold $113bn in foreign exchange in December, more than double
the previous peak rate of foreign exchange sales last August. (See Chart 1.)
• The common factor is that in both August and December the PBOC unveiled shifts in its management
of the renminbi. In August, the fixing mechanism was altered. In December, PBOC dropped strong hints
that it would in future manage the renminbi against a currency basket rather than the dollar.
• On both occasions, investors interpreted the shift as a possible precursor to devaluation and reduced
their renminbi exposure accordingly. We estimate net outflows last month came to just short of
$140bn, which again surpasses the previous peak seen in August.
• One way to view these events is that the PBOC is managing a desired depreciation. On this reading, its
interventions are only intended to slow the renminbi’s fall.
• The alternative view – which we think more likely – is that the PBOC hopes to keep the renminbi
broadly stable in trade-weighted terms but has botched communication of its policy and both last month
and in the summer has been surprised by the market reaction.
• Even if we’re right, there’s no guarantee that the PBOC won’t eventually be forced or choose to throw in
the towel. But there are several reasons to believe it will persevere for some time. First, reserves still
exceed $3.3trn, enough to burn foreign exchange at December’s rate for another two and a half years.
• Second, the economic benefits of substantial depreciation are not clear. As a statement posted on the
PBOC website today puts it, “the share of China’s exports in the global market expanded further in 2015
[...] Thus, it is not necessary for China to stimulate exports and stabilize growth through a competitive
devaluation of the renminbi.” There would be costs too for firms that have borrowed in foreign currency.
• Third, China’s leadership must consider reputational costs. China would be accused of being the
instigator of a global currency war. In a US presidential election year, political tensions would rise.
Efforts to establish the renminbi as an attractive global reserve asset would be dented.
• Nonetheless, there is certainly a sense that the situation is spiralling out of control. The announcement
this morning of a weaker onshore reference rate helped trigger another collapse in Shanghai equities,
even though the move in the reference rate simply reflected yesterday’s falls during trading. The wide
spread between onshore and offshore exchange rate points to further outflows in January. (See Chart 2.)
• The onus now is on the PBOC to counter the view that the renminbi will only go one way. We expect
heavier foreign exchange sales in the near-term to stabilise the onshore rate (the offshore rate was steady
today, presumably due to official action). Given the interventionist mindset in Beijing, capital controls
may also be tightened further, although this could backfire by giving investors an even greater incentive
to get out while they still can.
Mark Williams Chief Asia Economist (+44 20 7811 3903, mark.williams@capitaleconomics.com)

Chart 1: FX Reserves & Net Purchases of FX by PBOC ($bn) Chart 2: Capital Flows & Offshore/Onshore Ex. Rate Spread
120 PBOC net FX purchases (LHS) 4,500 60 400
FX reserves (RHS) 4,000
80
0 0
3,500
40
3,000
-60 -400
0 2,500

2,000
-120 -800
Premium of RMB offshore relative to onshore
-40
(pip, RHS)
1,500
-180 -1200
-80 Net capital inflows ($bn, CE estimate, LHS)
1,000

-120 500 -240 -1600

06 07 08 09 10 11 12 13 14 15 16 2012 2013 2014 2015 2016
Sources – CEIC, Capital Economics Sources – Bloomberg, CEIC, Capital Economics

China Economics Update