RMB Update: China Focuses on Quality v. Speed

Overview

• China’s major focus in 2018 is on quality v. speed of growth. The market expects a moderate slowdown in the growth rate from 6.8 to 6.5 percent.
• At the same time, the market expects China’s monetary policy to remain the same, with a focus on tightening. Authorities want to be in sync with other central banks while avoiding too much tightening as the economic growth slows down.
• The Trump administration threatens to impose trade sanctions against China, which would be a concern for the CNY. China de-emphasized Davos this year, while the U.S. took the spotlight.
• The offshore CNH gained 7.3 percent against the USD in 2017 and the onshore CNY rose 7.0 percent. Dollar weakness, regulatory guidance, and China’s on-target growth, have all contributed to the CNY’s advance.

2018 Country Updates

• The Chinese government prioritized stability in 2017, ahead of the 19th Party Congress and the 40th anniversary of major economic reforms. In light of the anniversary this year, the market expects a shift in the balance towards faster reforms and increased risk-taking.
• After targeting rapid growth rates for decades, China has shifted focus towards high quality growth at the end of 2017. There are high priority issues to be addressed, such as overcapacity, industrial upgrades, which the leadership aims to focus on over just the speed of growth.
• With this shift, China’s economic growth in 2018 will likely continue to slow down. Investors will need more leading indicators to better evaluate how well China is resolving domestic issues. Fixed asset investment, particularly private investment in fixed assets, will be useful measures.
• China’s monetary policy is expected to remain neutral this year. The PBOC has been facing a choice between loosening policy to stimulate the economy for more growth and tightening it to manage financial risks. The PBOC prioritized risk control over growth, which is also consistent with the leadership’s shift in economic goals towards quality of growth.

USD/CNH

• Chinese yuan set new record highs against USD this week, the highest since 2015: USD/CNH dipped 6.3882 in the offshore market and the USD/CNY traded as low as 6.3875 in the onshore market. A major risk will come from disagreements on US-China Trade, of which even talks of could hurt the yuan.
• From January to May of 2017, USD/CNH remained within range, despite the USD weakening in the same period. This caused natural concern around a failing exchange rate regime. Therefore, the PBOC introduced a counter-cycle factor for calculating the daily reference rate. This is a major adjustment in Chinese exchange rate regime since de-pegging the Chinese currency against the Dollar in August of 2015. After this move, the yuan restored momentum against the dollar in the third quarter and hit the yearly-high level of 6.4433.
• Chinese economic fundamentals have set the stage for a relatively stable yuan. The economy has avoided crashing and major financial disaster and is expected to meet or exceed the growth target. The PBOC also implemented a prudent monetary policy in 2017, which was already tighter than in 2016, and will continue to tighten.
• In terms of technical analysis, USD/CNH is trading at around 6.3954. For a bullish set up, a target could be 6.4426. If it stands above that level, the next focus will be 6.4785. In terms of a bearish set up, a key level to watch is 6.3557 where 2017 trend line converges with 61.8 percent retracement of the September 2017 advance.
• China’s domestic policies will continue to play a role in the exchange rate. The PBOC strengthened the daily reference rate for the dollar/yuan to 6.4169. However it is still nearly 200 pips away from the USD/CNH level at Friday’s close. A confirmation is needed from the regulator for the yuan to advance. Their focus is to increase the use of the yuan and maintain stability.

Risk Points to Watch Out For

• Top three economic risks include: (1) real estate investment stalls; (2) excessive capacity cuts lead to lower growth; and (3) escalating trade friction with the US pushes trade into deficit for China.
• A major driver of the real estate investment risk is the risk of a housing bubble. In order to manage this risk, the PBOC can cooperate to place further restrictions on home loans.
• Another issue on the regulators’ radar is undesired capital flows such as those to cryptocurrency. Last year three major Bitcoin platforms closed their China operations after the PBOC declared cryptocurrency Initial Coin Offerings (ICOs) to be illegal. Furthermore banks increased oversight on individuals using credit cards overseas, and the FX regulator SAFE strengthened its crackdown on illegal cross-border FX transactions. In parallel, China’s foreign reserves gradually increased for ten months consistently. In 2018, this gauge is expected to continue to impact regulators’ tolerance and oversight on capital flows.
• The Trump administration will decide by the end of this month about imposing trade sanctions against China. Trump has vowed to cut the U.S. trade deficit to China. Trump attended the annual World Economic Forum in Davos and delivered a speech about “America First”.  The odds that the US will take action has only increased, especially with record high trade imbalance announced last week. Trade conflicts may hurt China more than the US, and will be bad news for the yuan.