• RMB advanced on USD weakness but remained in broader ranges.
• Portfolio investments in local equities and bonds surpassed foreign direct investments.
• FX reforms may provide greater flexibility and could increase the number of participants.
Since mid-November, the RMB had advanced 1.3 percent against the greenback to a low of 6.5685 before retreating to 6.6100 currently. The main drivers behind the move have been the weakness of the USD and expectations for synchronized monetary tightening in Asia. On November 30th, Bank of Korea raised 25 basis points to 1.50 percent for the first time in 17 months. During the past two weeks, US treasury yields in the 2 years tenor rose 11 basis points to 1.76 percent, but instead of supporting the greenback, the USD index (DXY) lost -1.8 percent.
There was some focus on the flattening of the US yield with the 2 versus 10 year spread grinding to a low of 57 basis points from 75 at the start of November and 131 in January. This left the market a bit perplexed and some people trimmed their USD long positions as yield curve inversion scenarios are often signals for a recession. However, the debate on US tax reforms continues and this could help shape investor expectation and affect yield curve dynamics and the USD. On November 28th, the Chamber Budget Committee passed the Republican’s tax bill by a margin of 12-11 and this will go to the floor for a full Senate vote in the coming days. While many hurdles remain, this was a major step forward for the Republicans in their hope of getting the bill enacted before the end of the year.
Portfolio investments in equities and bonds
Foreign investments into Chinese equities and bonds have been robust due to the improved economic outlook, stable currency and optimism for financial reforms. In Q3, foreign investor inflows to local bonds reached a record of CNY 212 billion and equities also formed a 23 month high at CNY 153 billion. Collectively, the portfolio investment inflows of CNY 365 billion surpassed foreign direct investment (FDI) of CNY 224.5 billion in Q3 for the first time since Q1 2015.
Inclusion of China’s A shares into the MSCI Emerging Markets Index will commence next year in two phases starting in May and August, but given that it is only a partial inclusion of 5%, the near term impact is expected to be minimal. Nonetheless, this was a milestone in Beijing’s effort to attract global funds with an estimated USD 1.6 trillion that tracks the index to invest in the mainland. Perhaps, in the near future there may be potential for full inclusion and bond index inclusion as well.
FX reforms to provide greater flexibility
Rumors of a RMB band widening were dismissed by People’s Bank of China governor Zhou Xiaochuan in October, when he stated it was not a top priority for the central bank. This raised expectations that the next round of FX reforms may include relaxing rules for currency risk management and improving market efficiencies by allowing the necessary financial instruments for companies to better manage their FX risks.
At present, access to the onshore FX market by local and foreign entities are limited by underlying trades and investments. For foreign banks, FX flows and positioning are confined by the limits of their net open position. Given these constraints, the FX turnover onshore is only twice that of the offshore CNH market, although the RMB deposit base in the domestic market is significantly larger than the offshore with CNH deposits accounting for less than 1 percent.
By removing some of the restrictions and deepening China’s financial markets, we may see an increase in the number of participants as FX exposures expands. There will be more demand for FX hedging and allow the market to establish an equilibrium between supply and demand.
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