China Economics Seminar

One chart to show why China should worry about Fed tapering too

Ok actually there are two charts. The first one is the USDCNY intraday-interday chart. For those who have followed our blog for more than a year, it would not look new. If it is the first time that you see this chart, you can find the background of this chart here. The second chart is the assets held by the Federal Reserve since the beginning of quantitative easing. 

From the chart we can see that the onshore market's expectation of Renminbi appreciation since 4Q last year has been stronger than ever, after the depreciation expectation during 4Q2011 to 3Q2012. Coincidentally, the dramatic change of market's view on Renminbi was in line with the pace of quantitative easing in the US. It was during the interval between QE2 and QE3 when Renminbi was under depreciation pressure in the Chinese domestic market, and the depreciation expectation vanished very quickly after the launch of QE3 and we are seeing the strongest appreciation expectation ever since 4Q last year. Now everybody is talking about the Fed's tapering. The chart seems suggesting that the Renminbi would likely to face another round of depreciation pressure when tapering happens. 

Why should China worry if Renminbi is under depreciation pressure again?

FX inflow and outflow have tremendous impact on China's domestic monetary policy. When capital flows into China, in order to keep Renminbi exchange rate stable, the PBOC is forced to inject more liquidity into the banking system. Although someone may argue that the PBOC has issued bills and raised reserves to avoid excess liquidity injection, it does not seem to be the case. There are two problems here. First, the net bill issuance and reserve raising has never been enough to sterilize the capital inflow in recent years. Sun Guofeng, the deputy-head of PBOC's monetary policy department, said in his book that FX inflow can explain 25% of the deposit creation in China in the past decade. Second, PBOC bill itself is a quasi-money instrument as it is very liquid and people can use the bill as collateral to borrow so it is pretty hard to argue that issuing PBOC bills can effectively sterilize the excess liquidity. 

When capital flows out of China, as we saw from 4Q2011 to 3Q2012, domestic liquidity creation and monetary expansion would be much slower. Of course the PBOC can inject liquidity by cutting reserve requirement ratio or doing reverse-repos, but the problem is that China has enjoyed excess liquidity for so long that even if liquidity situation goes back to normal China would feel thirsty. If the central bank failed to be proactive, liquidity situation could only go worse. Moreover, what we are seeing this year is that very fast credit expansion led to pretty low GDP growth (by China standard), so what would happen to economic growth if credit expansion slows down? 

FX purchase has declined in May and the interbank rates in China have become unusually high since the beginning of this month, but it is just the beginning. The big story is yet to come. 


Central Banking Seminar

Chen Long