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The Chinese yuan (CNY) has been one of the best performing currencies in 2020. Yet, many continue to use the CNY as the vehicle to express bearish views on China. The arguments are familiar: China has too much debt, it is hiding poorly performing assets, it has a low return on investment and any moment now the country will collapse. Many see this as a reason for the CNY to devalue.
But we believe we are in the middle of a multi-year uptrend in CNY and downtrend in the USD. Importantly, this would help China’s economy to rebalance to consumption from export led growth. It would support efforts by the Chinese to promote the internationalization of their currency. For investors, Chinese bond markets offer a compelling proposition in a world of zero interest rates.
We could see USD/CNY fall towards 6.00 if not lower in the coming years. Our fair value estimates put USD/CNY at around 6.10, while popular valuation metrics like the Economist’s Big Mac Index have it between 3.80 and 6.54. Then, from a current account perspective, if China does indeed need to reduce its savings and run current account deficits, USD/CNY would likely need to trade down to 6. Therefore, our target is well within valuation ranges.
Would a China Crisis Lead to CNY Weakness?
Many bearish China arguments have some validity, notably the scale of non-performing investments. However, the transmission of a China crisis to the currency is not so clear. After all, there are numerous instances of crisis-hit countries experiencing stronger currencies. Think about Japan – after its bubble burst at the end of 1980s, the Japanese yen appreciated by 50% over subsequent years (Chart 1).
Moreover, reviewing banking crises in over 100 countries since the late 1970s, less than half saw a currency crisis. And most the countries that did were small countries such as Ecuador, Tanzania and Yemen. Of the larger countries that suffered banking-currency crisis, like Sweden (1991-1993), Korea (1997) and Turkey (2000-2001), all had fixed exchange rates that broke. Today, China does not have a fixed peg, rather it follows a managed float, which reduces any pent-up pressure that could lead to outsized moves. It is also noteworthy that when China itself did suffer a banking crisis in 1998 the then currency peg held. (Chart 2).
Aside from a fixed exchange rate, a common cause of banking and currency crisis is the prevalence of dollar loans held by residents. While China has had its moments of increased foreign currency loans, in recent years the share of overall credit accounted for by foreign currency loans has been steadily falling. Currently, they make up less than 2% of outstanding credit (Chart 3). Meanwhile, China’s FX reserves at over $3 trillion are 20% of Chinese GDP or eight times larger than foreign currency loans.
Watch the Overall Dollar Cycle
More important than the crisis argument, the dollar is close to multi-year highs and is likely at the beginning of a multiyear downtrend (Chart 4). We wrote about the dollar’s long-term cycles earlier in the year, but the main point is that the main multi-year supports of the dollar like high yields, investor repatriation and higher growth are behind us. Given that China is one of the largest weightings in the trade-weighted dollar, any dollar weakening trend would be reflected in a strengthening CNY.
On a bilateral basis, USD/CNY in real terms has been trending down and has yet to reach the lower levels seen in the 1980s (Chart 5). Of course, the structure of the Chinese economy has changed dramatically since then, so using a time frame that long is disputable.
Instead, we could look at how the (real) USD/CNY is trading relative to its more recent trend. On that basis, USD/CNY is 10% overvalued, which is close to the upper bound of valuations reached in the early 2000s (Chart 6). Back then, USD/CNY eventually fell to a 10% undervaluation. Assuming similar inflation rates between the US and China in coming years, a repeat drop would imply a 20% decline in USD/CNY towards 5.45.
China’s Rebalancing to Consumption
From a structural perspective, the real issue within China is chronic under-consumption. Since the reforms of Deng Xiaoping , China has gone on any investment and government spending splurge at the expense of households and domestic consumption. In the 1980s and 1990s China built out its infrastructure and lay the foundation for long term growth. But since the 2000s, the return on investment has fallen sharply, yet record high investment continues (Chart 7). This investment has been funded through extremely high savings rates, which depresses household consumption (Chart 8).
The remedy is for the economy to pivot towards consumption. Policymakers are aware of this, though vested interests make the transition hard. One clear way to achieve this rebalancing would be through a stronger currency. This would help importers (household) and hurt exporters. This in turn could reduce the required savings by households as their purchasing power improves.
The other way of looking at this is that China needs to move from being a current account surplus nation (excess savings) to a current account deficit nation. The trend in the current account has already been this direction. It peaked at over 10% in 2007 and has since been falling to around 1% in recent years (Chart 9). A 20% decline in USD/CNY would certainly speed up the move to a current account deficit.
There could also be a political imperative to rebalance towards domestic consumption and away from exports – deglobalization and protectionism. With the rise of populism, countries around the world are putting up barriers to imports. There is a greater drive for localization and import substitution. China, which was one of the biggest winners from globalization, could then become of the biggest losers in this new paradigm. China needs to encourage rebalancing from exports toward consumption to manage the downside risks from trade wars and external political/economic developments.
Watch Capital Flows
Capital flows could in the end hold the key to CNY strength. Up until this decade, China’s capital flows were characterized by large FDI inflows with large FX reserve accumulation to offset it (Chart 10). Now FDI flows have fallen to more sustainable levels and FX intervention flows have moderated. Instead, portfolio flows are likely to become the important swing variable for CNY.
Policymakers have been liberalizing the capital account to attract portfolio inflows. Chinese bonds have been included in global bond indices. Moreover, in the power play between the US and China, Chinese policymakers have been keen to reduce China’s use of the dollar and encourage the use of CNY. Already, CNY payments using China’s own cross-border payments system has grown substantially at the expense of CNY payments using SWIFT. Today, most major countries have banks that use CIPS (Chart 11)
Perhaps the most compelling feature of China are its interest rates. Buying CNY against the dollar, euro, or yen offers positive carry (one reason why it has outperformed this year). Furthermore, Chinese 10y government bonds offer a yield of 3% compared the US’ 0.7%, Germany’s -0.5% and Japan’s 0% (Chart 12). While foreign participation in Chinese bonds have grown, it is small compared to other countries’ like the US or various European markets. The same can be said for FX reserve allocations to CNY. It currently stands at 2% compared to 62% in USD, 20% in EUR, 6% in JPY and 4% in GBP (Chart 13).
As a sign of the internationalization of CNY, the IMF added the currency to its official currency basket, the SDR, in 2016. It’s weighting at 11% is the third highest after the dollar (42%) and the euro (31%). Later this year, the IMF will review the weightings, and this could see a further increase. While the SDR inclusion in itself may not lead to additional flows, it does mark an importance milestone in terms of the role of CNY in the global financial system. Other efforts such as Chinese lending to Belt and Road Initiative countries and launching a central bank digital currency will only add to this.
A new multi-year trend in CNY could be unfolding. The dollar is at close to its peak in its eight-year run of strength, the Fed has lowered rates to zero and given up hiking and the US twin deficit could be worsening. But more importantly, the CNY is cheap and needs to strengthen significantly to help China rebalance away from investment towards consumption. Fears of CNY weakness on any China crisis are overdone – Japanese yen strength after its bubble burst in the 1990s is testament to how currencies are often not the channel for a crisis to manifest itself. Moreover, China’s relatively high yields and greater bond diversification to Chinese securities could provide the capital flows to drive CNY higher. We would target USD/CNY to fall below 6.00 in the coming years.
See “Systemic Banking Crises Database : An Update” (2012), IMF ↑