Foreign reserve loss: exaggerated squeeze
Published 24 Nov 2011 15:15 by media
Top View| China
Foreign reserve loss: exaggerated squeeze
- Net foreign currency position of PBoC declined for the first time in recent years, raising market expectation for sizeable liquidity support by PBoC possibly in the form of deep cuts in RRR. The actual liquidity outflow from the onshore market was likely to be much smaller however as the fluctuations of the net foreign currency position can be heavily influenced by the size and direction of RMB denominated trade settlement. Such a currency substitution in trade transactions –which is sensitive to onshore and offshore exchange rate differentials- doesn’t have any liquidity impact on the onshore market.
- Domestic liquidity conditions still benefit from the trade surplus, FDI, and the positive yield differentials in the onshore and offshore market. While future RRR cuts are possible given the reduced net liquidity inflows, the focus on the foreign currency loss has exaggerated the urgency.
- Foreign currency positions will likely become more volatile in coming month, influenced by the rising two-way risks of CNY/USD, as we’ve argued.
Details: PBoC recorded the first monthly reduction in its net foreign currency position since 2007. On a net basis PBoC sold foreign currency in the amount of $4 billion during October, compared to an average monthly purchase of $50 bln in the first nine months of the year (changes in the foreign currency position correlate well with FX reserve fluctuations. The latter data is more lagged). This has increased market expectations of imminent measures by PBoC to support liquidity possibly in the form of broad RRR cuts. In past years the increase of net foreign assets (NFA) arising from balance of payments inflows has been the main source of liquidity for China’s money creation. For the most part PBoC has had to sterilize the inflows through open market operations combined with hikes in RRR. Recently the NFA increase has slowed but remained positive. If the NFA starts to decline as some will have interpreted the October data, PBoC may have to cut RRR significantly. The RRR cut announced yesterday targeted at a few rural credit coops fell well short of this expectation. Should the market expect imminent and significant RRR cuts in coming months?
While further RRR cuts are possible, we think the urgency has been overestimated as the change in foreign currency position exaggerates the onshore liquidity squeeze. What’s largely ignored is that currency substitution in trade and FDI flows could lead to just as much volatility in China’s foreign currency positions, even with the same underlying transactions. As an example, assuming trade balance is zero (thus there is no increase of NFA or inflow of liquidity) , if more Chinese imports are denominated in RMB than exports, there will be a long RMB position accumulated by non-residents and a long foreign-currency position by residents. Thus the country’s net foreign currency position will rise even though the NFA doesn’t change. Moreover, such a currency substitution does not change liquidity flows into and out of the onshore CNY market. For instance, trade flows denominated in RMB and those in foreign currency -once converted- will have the same impact on domestic liquidity, even though the foreign currency inflows add to foreign reserves and the RMB inflows don’t.
During October driven by global risk aversion and selling pressure of all emerging market currencies, the offshore CNH was significantly more depreciated than the onshore CNY. This encouraged net inflows of trade receipts in RMB. Say an importer of Chinese goods used to settle trade in USD, with the proceeds converted into RMB onshore through CNY/USD. She would now buy CNH/USD offshore and settle trade in RMB instead and splitting the saving from the exchange rate difference with the trading partner. In other words, there is incentive to pay for Chinese exports by buying CNH/USD offshore rather than buying CNY/USD onshore when CNH is more depreciated. This would reduce the accumulation of the foreign currency positions by PBoC, even though the same underlying trade took place. The pattern of currency substitution was the opposite in earlier months when the expectation for RMB appreciation was strong and CNH more appreciated than CNY. In that case Chinese importers were more likely than exporters to use CNY for trade payment, resulting in faster foreign reserve accumulation than the underlying inflows of liquidity.
The details of currency substitution through trade are not fully known (PBoC only publishes the aggregate RMB trade, without breakdowns of exports and imports, in low frequencies and with a significant time lag). However, around 8-9% of total trade is denominated in RMB or about $30 bln each month, substantial enough to influence the change in foreign reserves. The October market development also lent support to the absence of a liquidity squeeze. Though PBoC injected liquidity on a net basis, the injection was lower in October than in September, and the bond yields broadly trended down, countering the presence of a sharp liquidity shortage.
We could see more oscillation and volatility of foreign reserve changes in coming months as importers and exporters arbitrage across CNY/USD and CNH/USD. Consistent with the two way risk of CNY/USD as we warned investors in Top View| China | CNY: Time for more flexibility?, the diminishing appreciation pressure also gives PBoC more room to fix the rate according to market conditions. In recent weeks the CNY/USD daily fixing has become more volatile than earlier in the year.
Meanwhile domestic liquidity conditions still benefit from fundamentals such as the trade surplus, FDI, and the positive yield differentials in the onshore and offshore market and should be more stable. Net inflows have declined however, as trade surplus shrunk and the onshore-offshore yield differential narrowed. We will watch these indicators for future liquidity development. While further cuts in RRR are possible to complement other tools of liquidity management, such liquidity support will likely to be measured and selective in our view.
Li Cui
Non-Japan Asia Economics
+ 852 29662531
li.cui@rbs.com
www.rbsm.com/strategy
Bloomberg: RBSR<GO>
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