By Chetan Ahya
Economics: The Role of FX in the Deleveraging Cycle
Since the credit crisis, the rise in debt-fuelled investment in
China has been taking place against a background of slowing
additions to the workforce and also structurally weaker export
growth, hence lacking the productivity dynamic. Reflecting the
excess capacity issues in the industrial sector, producer prices
have been in deflation for the past 32 months while consumer price
trends have also been subdued. These disinflationary pressures have
resulted in slower nominal GDP growth and higher real rates, posing
challenges for policymakers to manage debt dynamics. Against this
backdrop, a crucial debate has been raised as to whether
policy-makers in China should engineer a sustained depreciation in
RMB in order to aid deleveraging efforts.
In our view, the experience of the U.S. deleveraging cycle
during which USD held relatively stable (as opposed to a sustained
depreciation trend) as the U.S. economy successfully achieved a
stabilisation in its debt dynamics suggests otherwise. To be sure,
a weaker currency can play a supportive role in the management of
debt dynamics, particularly if most of the external debt of the
economy is denominated in local currency; however, we argue that
the management of real rates versus real GDP growth is more
critical.
In addition, we see challenges for policy-makers in engineering
a sustained depreciation. Real rate differentials are supportive of
renminbi (RMB) and, as per our forecasts, real rate differentials
are unlikely to narrow significantly in the coming 12-18
months.
With the onset of disinflation pushing up real rates and
policymakers' ongoing attempts to reduce misallocation of financial
resources, fixed asset investment growth has been weak. If
disinflationary pressures were to persist, high real rates would
weigh on domestic demand growth and, in this scenario, current
account surpluses, as represented by the savings investment gap,
would likely increase. This would make it even more difficult to
engineer a meaningful, sustained depreciation in the trade-weighted
exchange rate.
FX Strategy: Putting RMB Under the Microscope
Given the strong USD backdrop, China's monetary conditions have
been tightening due to tight credit lending, high real interest
rates and a strong real effective exchange rate. China will focus
on reforms and continue to promote the critical transition of its
growth model away from exports and investments towards domestic
consumption. Furthermore, a weaker RMB could lead to significant
outflow risks and consequent hedging demand in FX additionally
resulting in an adverse monetary impact on the domestic economy.
This would also not align with China's ambitious plans for RMB
internationalisation.
Therefore, we do not expect China to use RMB as a policy tool to
support growth. The currency is likely to remain stable in the
years ahead with a mild appreciation bias, we believe. Potential
costs of weakening RMB could outweigh the potential benefits, in
our view. Having said this, if China's macro outlook and flow
dynamics remain stable alongside external macro volatility staying
relatively low, we see a likelihood of China perhaps increasing
RMB's two-way volatility in 1H (especially in 1Q when the trade
balance and current account balance are seasonably weak).
Global FX Implications of RMB Policy
The impact on the global economy from the path the People's Bank
of China (PBoC) takes cannot be emphasised enough. With global
disinflation very much at the fore of macroeconomic concerns, a
policy adopting the weakening of RMB, allowing China to export
deflation abroad, will only add to existing issues. While China's
policymakers look to provide some support to domestic growth to
eschew a disorderly rebalancing, using FX weakness as the policy
tool could have substantial negative implications for
disinflationary currencies, especially within Asia, we argue. SGD,
KRW and THB would be most vulnerable, given large trade linkages
with China and already low inflation.
In addition, China joining the global trade of deflation would
increase pressure on other central banks to take further dovish
action in order to support dangerously low inflation expectations.
In the case that the ECB takes further action to counter the PBOC's
RMB weakening policy and weakens EUR, we also see an indirect
negative impact on other 'lowflation' currencies against USD. As
such, this outcome could be potentially negative for EUR, CHF, SEK
and JPY within G10, and ILS, PLN and HUF within EM.
We also evaluate the broad global FX implications of three
separate scenarios: I) Our base case in which the PBOC stays
neutral on RMB and no active changes are made to FX reserves; II)
The PBOC fixes USD/CNY higher to weaken the currency while keeping
FX reserves stable; and III) The PBOC buys USD reserves to weaken
RMB in order to support domestic growth and inflation, similar to
1Q this year.
In summary, our base case remains that the PBOC will not use FX
as a policy tool to buttress domestic growth. In the event that it
does, we see potentially negative implications for disinflationary
currencies, as well as commodity currencies, depending on the
policy adopted on FX reserves.
This is the executive summary of a longer Economics and Strategy
Insights report written by Morgan Stanley economist Chetan Ahya and
his fellow economists Derrick Kam and Jenny Zheng, and fixed income
strategists Kewei Yang and Vandit D. Shah.
---
To be considered for this feature, please submit material
to:
Email: asiaresearch@barrons.com
---
Comments? E-mail us at asiaeditors@barrons.com