PBOC Intervention and the Renminbi

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1 Thomas Shik Senior Economist PBOC Intervention and the Renminbi The People s Bank of China (PBOC) has stated that it has basically stopped periodically intervening in the country s currency market. Supporting this claim is the fact that the PBOC s foreign exchange assets were little changed in However, the PBOC has been conducting more liquidity operations, which have become the main source of funds for the banking sector and put downward pressure on the renminbi (RMB). Our forecast is for the RMB to fall by about 1.5% in 2015 to end the year at about 6.30 versus the US dollar. With the exchange rate currently hovering around 6.28, the risk is on the downside. March 2015

2 Has PBOC intervention basically stopped? Despite a slowdown in its economy over the past couple of years, mainland China has continued with currency reform efforts. In March 2014, the People s Bank of China (PBOC) widened the daily trading band of the renminbi (RMB) against the US dollar (USD) on the onshore interbank market to +/- 2% (from +/- 1%) of the PBOC mid-rate. More recently, the central bank has stated that it has basically stopped periodically intervening in the country s currency market 1. In order to assess this statement, it is necessary to understand what impact intervention by the PBOC has on its balance sheet. While the RMB is linked to a basket of currencies, the following example using USD should serve as adequate illustration. A foreign investor deposits an inward investment of USD1 at a bank on the Mainland. The bank must then convert the USD into RMB, which is not freely floated. If the PBOC intends to control the RMB and maintain a high degree of exchange rate stability, it may buy the USD1 from the bank, and print and sell the equivalent amount in RMB at its desired exchange rate RMB6 for the purposes of this example in return 2 (Exhibit 1). The USD1 will be recorded as foreign exchange on the asset side of the PBOC s balance sheet and the newly printed RMB6 as reserve money on the liability side. Conversely, if there is an outflow, both the asset and liability sides of the PBOC s balance sheet will be reduced (Exhibit 2). Exhibit 1: Fund Inflows PBOC Commercial bank's deposits 2 Foreign exchange USD 1 USD 1 2 (part of reserve money) (recorded at cost in RMB 3 RMB 6 (converted into RMB) RMB 6 3 for accounting purposes) Commercial bank 1 Cash USD 1 Customer deposits USD (converted into RMB) RMB 6 (converted into RMB) RMB 6 4 Source: Hang Seng Bank 1 The People s Bank of China, Mainland China Monetary Policy Implementation Report, 2014 Q4. 2 Assuming that the Mainland commercial bank cannot clear the transaction itself or in the interbank market. March

3 Exhibit 2: Fund Outflows PBOC Commercial bank's deposits 2 Foreign exchange - RMB 6 - RMB 6 2 (part of reserve money) (foreign exchange assets 3 - USD 1 (converted into USD) - USD 1 denominated in USD) 3 Commercial bank 1 Cash - RMB 6 Customer deposits - RMB (converted into USD) - USD 1 (converted into USD) - USD 1 4 Source: Hang Seng Bank Movements in foreign exchange assets on the PBOC s balance sheet should therefore show how frequently the Mainland s central bank intervenes in the currency market. In theory, the PBOC s foreign exchange assets (FX assets) should be identical to the Mainland s foreign exchange reserves (FX reserves), for which figures can be separately obtained from the State Administration of Foreign Exchange (SAFE). In reality, however, there are discrepancies between the two because FX assets are valued at historical costs in RMB, while FX reserves are measured in USD and subject to valuation changes when exchange rates fluctuate (Exhibit 3). We therefore consider FX assets to be a better indicator of the extent to which the PBOC is intervening in the currency market. Exhibit 3: FX Assets & FX Reserves March

4 The example above also suggests that FX assets can be viewed as a measure of cross-border capital flows on the basis that if the PBOC actively manages the RMB, its FX assets should reflect net changes in capital flows. However, many financial market observers are instead closely monitoring foreign exchange purchases by Mainland banks (FX purchases). Our view is that there are no major differences between the two and that they have a high correlation to each other (Exhibits 4 and 5). Arguably, however, FX purchases are a more accurate measure because there is a possibility that Mainland commercial banks clear foreign exchange transactions themselves and the PBOC does not have to take any action at all. Exhibit 4: FX Purchases & FX Assets Exhibit 5: FX Purchases & FX Assets A closer look at PBOC s balance sheet The PBOC s FX assets were little changed in 2014, implying that the central bank had exited from its previous pattern of foreign exchange market intervention. In its latest quarterly monetary policy report, the PBOC said that it had basically stopped periodically intervening in the country s currency market and that liquidity injections via policy tools had replaced buying foreign exchange with RMB to become the primary means of providing funds for the banking sector. The PBOC s net purchases of foreign exchange, as reflected in its FX assets, were RMB641 billion in 2014, while its claims on banks and non-bank financial institutions rose by RMB1.08 trillion, accounting for about half of the increase in the size of the PBOC s balance sheet in (Exhibits 6, 7 and 8). 3 According to the PBOC, its liquidity injections amounted to about RMB2 trillion in Our opinion is that this amount is presented on a gross basis. The net amount of injections, as shown on its balance sheet, was RMB1.08 trillion. March

5 Exhibit 6: FX Assets & Reserve Money Exhibit 7: FX Assets (% of Reserve Money) Exhibit 8: PBOC Balance Sheet PBOC (RMB billion) Change (RMB billion) Change Foreign exchange 26,427 27, Reserve money 27,102 29,409 2,307 Other foreign assets Non-reserve money deposits Claims on Government 1,531 1,531 0 Bond issuance Claims on banks & non-bank Fis 2,206 3,283 1,077 Foreign liabilities Claims on non-financial sector Deposits of Government 2,861 3, Others 765 1, Other liabilities Capital Total 31,728 33,825 2,097 Total 31,728 33,825 2,097 Source: PBOC, Hang Seng Bank The PBOC s FX assets were also steady in 2012, before rising in Does this mean that the central bank did not intervene in the currency market in 2012 but resumed such activity a year later? Answering this question requires consideration of the US Federal Reserve s monetary policy. While the RMB is pegged to a basket of currencies, it is widely believed that the USD has a heavy weighting in the basket and thus the PBOC s monetary policy is highly influenced by the actions of its US counterpart. March

6 In general terms, the PBOC needs to follow in the Fed s footsteps if it wishes to maintain the RMB peg. An expansionary monetary policy in the US is likely to increase the risk of the RMB appreciating against the USD and of funds flowing into the Mainland unless the PBOC also loosens its policy by buying USD in the markets with the RMB it prints. If the PBOC pursues such policy of easing, its balance sheet will grow with a rise in FX assets on the asset side and reserve money on the liability side. Conversely, the PBOC s balance sheet will shrink if it follows Fed initiatives to tighten monetary policy. In recent years, the size of securities held outright by the Fed has been a good indicator of the Fed s policy stance. After cutting interest rates to almost zero in December 2008, the Fed resorted to buying securities outright as a way of boosting economic growth. It halted purchases during much of 2012 after implementing Operation Twist a plan to sell short-term bonds while purchasing longer-term securities but then launched another round of purchases later that year. As a result, the Fed s securities holdings were little changed in 2012 before rising again in 2013, a trend which continued into 2014 (Exhibits 9 and 10). The pause in purchases explains why the PBOC s FX assets were also steady in 2012, as the PBOC basically followed the Fed in putting its previous policy on hold during that year. Exhibit 9: FX Assets & Fed s Securities Holdings Exhibit 10: FX Assets & Fed s Securities Holdings March

7 Fewer FX operations The Fed continued its purchases of securities until October For the whole of last year, the Fed s securities holdings rose, but the PBOC s FX assets were left largely unchanged. This seems to lend considerable weight to the PBOC s statement that it had refrained from intervening in the currency market. That said, there is still the possibility that the PBOC intervened in the market, buying USD with RMB, and then selling back roughly the same amount of USD to meet increased capital outflows. In our view, it is difficult to tell whether this actually happened, although the latest balance of payments data shows that the Mainland saw a substantial increase in its capital and financial account deficit in the fourth quarter of 2014, implying a jump in capital outflows (Exhibit 11). Exhibit 11: Balance of Payments More liquidity operations, impact on RMB The above study on the PBOC s currency intervention suggests that, in 2014, the PBOC printed and sold more RMB than that it should under the current exchange rate regime. The central bank bought RMB641 billion in foreign exchange but issued RMB2.3 trillion in reserve money. The difference was mainly reflected in a surge in claims on banks and non-bank financial institutions on the asset side of the PBOC s balance sheet. This activity supports the PBOC s claim that its liquidity operations have replaced buying foreign exchange with RMB to become the main source of base money supply. March

8 Intuitively, the value of the RMB should fall when the PBOC issues currency that is not fully backed by USD. This is perhaps why, from an economic perspective, the RMB has come under increased selling pressure in the past year or so, falling by 2.4% versus the USD in 2014 and by about 1.1% year-to-date 4 (Exhibit 12). It should also be noted that, in previous years, the RMB continued to rise when the size of FX assets was bigger than that of reserve money (Exhibit 13). Exhibit 12: RMB versus USD Exhibit 13: FX Assets & Reserve Money Looking at the issue from another angle, given that the Mainland continues its gradual capital account opening, it is not surprising to see increased downward pressure on the RMB following the PBOC s policy easing. After all, it is impossible to have an independent monetary policy and free capital mobility across borders without allowing greater flexibility in its exchange rate 5. Our forecast is for the RMB to fall by 1.5% in 2015 to about 6.30 versus the USD by the end of the year. With the exchange rate hovering around 6.28 at the time of writing, the risk is clearly on the downside. 4 Calculated according to the RMB onshore rate. 5 This is the constraint of the Impossible Trinity or the Trilemma in international economics. March

9 China Economic Monitor Statistics March 2015 GDP Industrial output Fixed asset investment Retail sales Nominal Real Real Nominal Nominal Foreign trade Consumer prices Exports Imports Trade balance Food Non-food RMB bn yoy (%) yoy (%) ytd (%) yoy (%) yoy (%) yoy (%) USD bn yoy (%) yoy (%) yoy (%) , , , , , F NA Q , Q3 13, Q4 18, Q , Q2 14, Q3 15, Q4 21, Oct 2014 NA NA Nov NA NA Dec NA NA Jan 2015 NA NA Feb NA NA YTD NA NA Deposits (domestic currency) Loans (domestic currency) New loans Lending rate 1-year Money supply (M2) Forex reserves Foreign direct investment CNY per USD (period end) Total social financing RMB bn yoy (%) RMB bn yoy (%) RMB bn % yoy (%) USD bn ytd (%) RMB bn , , , , , , , , , , , , , , , , , , , , , , , , , F 122, , , , ,000 Q , , , , ,980 Q3 103, , , , ,808 Q4 104, , , , ,322 Q , , , , ,600 Q2 113, , , , ,920 Q3 112, , , , ,280 Q4 113, , , , ,503 Oct , , , Nov 113, , , ,146 Dec 113, , , ,695 Jan , , , NA ,051 Feb NA NA NA NA NA 5.6 NA NA NA NA YTD 122, , , , ,051 NA: not available; (A)= actual; (F)= HASE forecast; yoy= year-on-year; ytd= year-to-date Source: State Statistical Bureau, China Statistical Yearbook, Reuters EcoWin, CEIC, Hang Seng Bank March

10 GDP Growth Consumer Price Inflation Urban Fixed Asset Investment Retail Sales Loan & Deposit Money Supply (M2) Benchmark Interest Rates Exports & Imports March

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