CNY at an inflection point
Part II: {reading time ~8-10 minutes}
Xi Jinping proposed to pursue a Dual Circulation strategy in Politburo meeting in May 2020. It turned a nebulas discussion into a meaningful policy pivot. The dual circulation strategy is a two-pronged development strategy that seeks to spur China's domestic demand ("internal circulation") as well as cater to export markets ("international circulation"). The plan aims to create conditions that balance domestic and foreign needs. What is China's Dual Circulation Strategy?
In practice rest of the world sees this as being connected to China for their import needs but cut off to China’s domestic economy. The internal and foreign government policies have led to a faster decoupling of China with the west, showing no sign of deaccelerating. China's COVID-19 response of shutting borders has helped China keep its export engine growing, leading to a record trade surplus. While the domestic economy has seen successive policy changes, and the internal economic slowdown is balanced by external demand.
Shutting Its borders has meant imports of Invisibles like education and tourism have fallen.
The policy changes aimed at large technology, education, and property are already leading to a shift in attitudes towards consumption and confidence.
What drives strong Yuan, best performing bond market, somewhat bipolar short-term rates, and balance of payments?
Trade balance / errors & omissions / foreign exchange reserves
China's trade surplus is at record levels (YTD $499) billion after falling sharply at the start of Covid-19 (Blue bar). However, the Foreign Exchange reserves (purple line) have grown at a much slower rate (YTD $146.6 billion), raising the question of capital outflows.
Errors and Omissions are an excellent way to look at official outflows data. For the 2nd Quarter of 2021, the figure was $66.6 billion and a total of $150 billion YTD. The following quarter figures should shed light on the trend and perhaps indicate why the authorities are now stepping up efforts to regulate gaming, crypto, and travel to curtail capital outflows.
The other less quantifiable route of capital outflows is through Macau Junket and online gambling, which do not require gamblers to leave China. Macau annual betting was estimated to be $36 billion in 2018, of which estimated Junket accounted for up to 70% of the bets. Alan Chau's arrest signals closing this money laundering/outflow loophole.
China has been clamping down on crypto trading and mining. They are aware of the Crypto role in capital flight.
These measures are contributing towards enforcing the dual circulation policy.
Long term trade surplus/ foreign exchange reserves/errors and omissions
The 2015 significant errors and omissions led to draconian limits to capital control measures. Will we see similar moves?
Could the trade surplus be held with Chinese commercial banks? Their rising balance suggests there is some evidence to support this.
Foreign exchange deposits
At the end of September, foreign currency deposits stood at $992.67 billion, a YTD increase of nearly $104 billion, likely to be unhedged exporters' positions. Typically, exporters hedge 35-65% of receivables. Last week PBOC increased foreign exchange reserve requirements, and this balance may have been the intended target.
However, USDCNY's strength was met with exporter selling and hedging northbound flows.
The PBOC move has not resulted in a lasting strength of USDCNY.
Bipolar forward implied rates send a mixed signal of corporate USD needs.
USDCNY Implied Yield Curve and SHIBOR (as of 3rd December)
When EM corporates must have USD cash on their balance sheet by a specific date, they buy USDCNY in the short end, sell in a longer tenure, and take USD delivery. If enough corporates do this, an inverted forward implied yields curve results. Implied yield curves during this period are higher than local money market rates.
Since the end of November, corporates have been doing this to get USD on their balance sheet by year-end.
An inverted FWD implied curve is supportive of the USDCNY spot rate even though their transaction is a buy and sell in forwards.
USDCNY Implied Yield Curve and SHIBOR (10th December)
The forward implied curve has moved lower but remains inverted from December onwards. Higher the implied short-term rates over SHIBOR, the higher the demand for USD cash.
In a period where the USD is broadly stronger, Yuan has strengthened to its highest level since May 2018.
USDCNY long term chart
The currency pair is testing the uptrend from 1992, and the weekly trend line shows no clear break.
While downward bias for the USDCNY is intact, the trend has not accelerated after breaching daily charts support.
We treat this as an Inflection point and look at the technical and fundamentals that could drive the trend or cause a reversal of the downtrend.
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USDCNY medium-term chart
Record daily Northbound stock inflow on 9th December and week ending 10th December have kept the pressure on USDCNY.
Inflows into the best-performing government bond market have added to the downside pressure on USDCNY.
Since its inception, the stock Connect has contributed net inflows of RMB 1.5 trillion ($272 billion) into mainland A-shares.
This Bond inflow has taken foreign ownership to $376 billion as of the end of November.
Add the record exports, and we can see drivers of a stronger CNY.
USDCNY short term chart (a bearish playbook)
A break of the uptrend from 2015 has not seen an impulse follow through, nor is there a case for reversal based on Friday’s close.
A break from last week’s lows strengthens the bear case, but we need to be mindful that PBOC will take measures to slow the downtrend.
We cover some drivers that could take the pair down to 6.08 (triangle extension target and yearly Pivot point S3).
Positioning
10D risk reversal vs. spot
The 10 and 25* delta risk reversals* still indicate positioning in favor of short USD. Exporters and portfolio inflow hedging demand have neutralized Thursday’s USD strength.
There is unlikely much speculative positioning given onshore regulations, reflecting real money flows.
Consumer Confidence
If consumer confidence does not fall sharply, the government will continue its unwinding housing leverage, gradually slowing the economy to a 5% growth target while lowering rates.
Stable policy response helps maintain portfolio inflows and keep the savings rate up.
Urban depositor confidence: future earnings
A lower future earnings expectation should result in lower inflation expectations.
Lower domestic inflation against rising global inflation is a case for a stronger CNY.
Higher saving rate & fiscal deficit
Like Japan in 1991*, China has an aging population, sharply rising dependency, and high savings ratios. Japan started unwinding of extremely high property prices in 1997. China may be about to follow a similar playbook.
A similar playbook would call for a stronger currency, falling real yields, at least for part of the timeline.
Even though a large proportion of China's savings is in the form of property, a measured unwind over many years, along with higher fiscal deficit and capital controls, support a stronger CNY.
The Central Economic Work Conference sets the economic plan each year; it states lower growth and coordinated monetary and fiscal policies for 2022.
A clear sign for a higher deficit will be tolerated for 2022 and beyond.
USDCNY the other side of the inflection point
While we don’t yet have a case for stronger USDCNY, we would look for signals for a trend reversal. Some of the signs are
1) An impulse moves to 6.47, the essential prerequisite
2) A sustained reversal in portfolio inflows
3) A sharp drop in industrial production & exports
4) South China sea geopolitical event
5) PBOC imposing punitive costs to hold to USD outside of state control
6) Falls in Korean Won & Japanese Yen vs. Yuan (real and Nominal), making China exports uncompetitive
Real effective exchange rate
CNY's real effective exchange rate is approaching its highest level since 2016. While it favors imports, the government could pressure PBOC and SAFE if exports fall.
Nominal US-CN 10-year yield differential
The 10-year nominal yield differential supports USD; however, real yield differentials are fundamental for the long-term trend.
Real yield differential using core CPI
Given the lag in CPI data, we will have to see policy response which is likely front-run the data.
China's core and headline CPI should start to fall due to slowing house prices, consumer confidence, earnings, and rising dependency ratios.
US-CN 2-year nominal yield differential
The two-year yield differential is supportive of stronger USD. But PBOC guidance to keep lending rates lower to support SME and industrial lending may cloud the use of the measure.
Takeaways
We look for an impulse move up in USDCNY to indicate the bull case is on the table. Until then, the trend should head lower towards 6.08.
With one of the most significant shifts in the largest global asset class and government trying to slow down population decline, the holy grail has many moving parts.
The Hong Kong Dollar, under tight oversight, will likely take the role of external outflows. For now, it is not a Texas hedge.
We are in a downtrend, or we confirm a false breakdown. Either way, we hopefully have a game plan.
Appendix
25 Delta Risk Reversal
Risk reversal can be used as a hedging strategy for options trading. An investor buys one option and writes or sells another within the same expiration month. This type of strategy is designed to help options traders minimize downside risk when taking long or short positions. It’s typically more common to seek risk reversals when trading options for commodities or forex, though stock options traders can also employ them.
Japan Dependency Ratio bottom and 10-year Yields peak coincided
China Dependency ratio bottomed around 2012-2013
Secondary peak USDJPY and Nikkei started a long term trend down in 1991
China’s headline versus core CPI’s
It is tough to estimate the weight of the core CPI in the headline index, as the NBS seldom releases the contribution of changes in energy prices to changes in headline inflation. We use 92# gasoline as a proxy for energy prices to get around this. Based on this method, we est
imate that the core CPI (excluding food and energy) accounts for 77-78% of the headline CPI, while power accounts for a mere 2-3%.
Source: Bloomberg