Two-Way Bets On The RMB Begin To Emerge

The 2.2% appreciation in the RMB since May suggests that capital inflows into China remain strong, and the authorities will likely use administrative measures to clamp down on any speculative behavior in the future, says a research report issued by the Australia and New Zealand Banking Group Limited (ANZ).

When China’s forex reserves data for the third quarter were released two weeks ago, showing a decline of US$105 billion in the quarter, there was much speculation about potential capital outflows, and that the Chinese central bank had to intervene to sell dollars in the market.

But this week’s release of the People’s Bank of China’s net forex purchase data showed that the central bank had been largely absent from the forex market since May.

For the third quarter, the PBoC had only sold a marginal US$2 billion, indicating that most of the decline in the third quarter forex reserves were due to valuation changes.

The fact that most of the decline in the third quarter reserves were due to valuation changes should not have come as a surprise in the first place.

Around 30% of China’s forex reserves are in Euros and Japanese Yen assets. Given that the Euro and the Japanese Yen fell by almost 8% during the third quarter, valuation losses from assets denominated in these two currencies alone would have amounted to over US$90 billion.

Weaknesses in the British Pound, Australian dollar and other currencies would have accounted for the remaining valuation losses.

The absence of the PBoC from the forex market means that moves in the onshore RMB spot have been purely market-determined since May. Given that the RMB has appreciated by 1.8% between May and September, and a further 0.4% so far in October, this adds weight to the notion that China experienced capital outflows.

If there were genuine capital outflows, the yuan would have been under depreciation pressure. Of course, this is not to say that outflows did not occur. But the strengthening in the yuan in recent months show that on balance, inflows from the trade surplus, portfolio and other sources more than outweigh any outflows.

Normally, capital outflows would occur if there were genuine expectations of currency depreciation. At present, there are signs that cross-border financial arbitrage has re-emerged based on the recent trade data, a sign that RBM appreciation expectations by onshore entities are strong.

For example, the September data showed a sharp increase in the discrepancy between how much China said they exported to Hong Kong (US$37.6 billion), and how much Hong Kong said they imported from China (US$24 billion).

This US$13.6 billion discrepancy is not as large compared to March and December 2013, when over-invoicing and round-tripping was at its peak. But the spike does point to the practice returning.

Unlike early 2013, when transactions using the bonded area were used as a channel to over-invoice, it appears that traders are now using precious stones instead.

Precious stones are small, easily transportable and high value, making it easy to exaggerate their prices to inflate the export value. About 92% of China’s reported precious stones exports go to Hong Kong, and the large spike in September helps explain a large part of the discrepancy between the China-Hong Kong trade data in that month.

But this time, the import side has been inflated as well, judging from the sharp rise in imports of precious stones. There was a large jump in precious stones imports to US$10.7 billion from US$3.2 billion the previous month.

Imports from Korea jumped to US$3.5 billion from US$0.6 billion previously, and imports from Myanmar have gone from zero a year ago to US$4.7 billion currently.

The sudden rise in the export and imports of precious stones in China can hardly reflect genuine trade flows. There is a clear speculative element re-emerging to bet on RMB appreciation.

But it appears that the speculative flows may also be two-way, given the over-inflating of imports to channel funds to Korea and Myanmar.

Hence, both exports and imports in China’s trade data appear to have been overstated in September, which mean that overall impact on the trade balance and on net export contribution to growth may not have been as large as initially thought.

Earlier this month, the head of the State Administration of Foreign Exchange (SAFE) Yi Gang said that while China will further develop its foreign exchange market to support RMB reforms, the regulator will crack down on illegal currency dealings to help prevent big speculative flows in and out of the country.

ANZ says it does not expect the authorities to engineer a fresh round of currency depreciation to stamp out the speculative flows like they did between January and April this year.

It is more likely that the authorities will use greater oversight to clamp down on non-genuine trade flows. The PBoC’s hands-off approach to currency intervention may continue, there will be ongoing modest appreciation of the RMB on the back of ongoing trade surpluses and foreign investor demand for onshore RMB assets.

China Expert network