Based on the torrent of research notes that have hit our inbox today, the macroeconomic community remains divided over the challenges facing Chinese policymakers in the period ahead.
Weaker economic growth, accelerated capital outflows and financial market instability are concerns that continue to bubble away underneath the surface.
Some are not concerned, but that’s hardly a universal view. More radical forms of policy stimulus, a looming banking crisis, along with the potential for a sharp depreciation in the Chinese renminbi, have all been floated as potential outcomes that may arrive over the course of the year ahead.
While they don’t expect an imminent banking crisis, nor an increase in financial market volatility as a result of weak economic data alone, Ajay Rajadhyaksha and Jian Chang, members of Barclays cross asset research team, believe that Chinese policymakers will likely face a tough decision when it comes to the renminbi in the period ahead.
“In chess, the concept of zugzwang refers to a point in the game where any change in the status quo weakens a player’s position,” wrote the pair in a research note released overnight.
“The ideal choice would be to not make a move, except that ‘pass’ is not an option.
“This concept effectively explains the choices that confront China’s policy makers, who will have to make a decision about the country’s currency and monetary policy in the next few quarters. None of the choices are terribly appealing, and all carry risks for financial markets.”
Rajadhyaksha and Chang’s concerns, like others, revolve around the sharp decline in Chinese FX reserves seen in recent months.
However, unlike others, they do not believe that portfolio revaluations nor concerns surrounding the outlook for China’s economy are the main reasons for decline seen over the past six months, pointing to easier monetary policy settings from China’s central bank, the PBOC, as the main catalyst behind the accelerated decline.
“We believe that outflows are not being driven just by a loss of confidence, but are a by-product of sharply easier monetary policy, which resulted in M2 in the country rising by around $2.5trn (in RMB equivalents) last year,” say the pair. “While this wave of RMB liquidity continues to wash over the Chinese economy, capital outflows should continue.”
Should this, rather than other factors, see FX reserves continue to decline, Rajadhyaksha and Chang believe that policymakers will have only three options to stem capital flows, and none of them will be particularly palatable for markets.
China could tolerate the current pace of FX reserve declines for several more months. But at some point this year, the People’s Bank of China (PBOC) will probably have take more aggressive measures to stem outflows. The choices are: a) strict capital controls; b) a much tighter monetary policy; or c) a sharp, one-off depreciation of the RMB. We do not think capital controls will work, and monetary policy tightening could slow down the economy, as well as spark credit defaults. A one-off depreciation would have to be sharp enough that it shifts psychology from future depreciation to appreciation, thus reducing capital outflows. The RMB has appreciated 25-30% trade-weighted over the past four years; all of that might need to be unwound to decisively shift psychology. But this would be a difficult “sell” in other countries, especially in a US presidential election year.
Rajadhyaksha and Chang believe that the PBOC may try each of these in small doses in the months ahead, testing the waters to see what, if any, will be able to reduce mounting capital outflows.
However, if these steps fail to stem the tide, they believe China will have a tough decision to make, with the ramifications to be felt worldwide.
“The choices the country makes over the next few quarters will have ramifications for the global economy, as well as for world financial markets. And at least right now, there do not seem to be any easy choices on the horizon.”