China: Probability of shifting to complete market-determined FX regime is very low - Nomura

Craig Chan, Research Analyst at Nomura, suggests that the probability of China shifting to a complete market-determined FX regime in the near term is very low in their view, and the current path of periodic FX flexibility and active FX intervention is likely to continue over the next 12 months at least.

Key Quotes

“However, if China were to suddenly adopt a completely free-floating FX regime (removing the 2% daily trading band on onshore spot) and not intervene in the FX market, we believe RMB would depreciate rapidly and significantly overshoot our current view of 4% RMB TWI overvaluation. Indeed, the risk is that rapid RMB depreciation would lead to a sell-off in local markets and feed through to greater negative regional and global market contagion.” 

“China is already facing large net capital outflows under the current FX regime where it has been allowing for some FX flexibility and intervening sporadically in the FX market. Adjusted FX reserves are down USD459bn over the past 12 months to October 2016, while our measure of capital outflows (adjusted FX reserves less basic balance) totaled USD722bn in the same period. A free float and likely surge in RMB depreciation expectation would see locals accelerate their diversification into foreign assets (around 27.3% of GDP in Q2 16 or USD3tn) as well as risk another round of deleveraging in foreign currency liabilities.”

“We note that when RMB depreciation expectations started to rise from around mid-2015 and China eventually shifted its FX regime and adjusted the FX rate on 11 August 2015, our estimates show that there was around USD597bn of net capital outflows in H2 2015. This was led mainly by USD254bn of foreign currency loan deleveraging (Q2 16 FC loans last at USD753bn), exporters hoarding USDs and strong USD demand from importers (trade settlement deficit of USD110bn), and a USD105bn E&O deficit.”

“The risk of China shifting to a free float at this juncture could lead to a severe balance-of payments shock with serious negative economic/financial market consequences. As such, even though China’s long-term goal is to move towards a free float, over the next 12 months (at least) the authorities are likely to take only a gradual approach by allowing for some periods of FX flexibility, but still manage large and structural capital outflows. We believe this stance is still currently sustainable, but the challenges seem significant, given global monetary policy and political developments, local macro risks from high debt levels, and a backdrop where local desire for foreign assets remains severe.”