China's markets have been closed since the end of September and re-open
tomorrow. It is interesting to note what has happened in the global capital
markets in the interim. The US dollar has fallen against all the major currencies,
but the Japanese yen, which is off about 0.2%. Major equity markets are 3%-5%
higher. US and Germany benchmark 10-year bond yields are up about 3 bp, though
UK gilt yields are up 9 bp, with half of this gain being recorded today. Many
industrial commodity prices are higher, with the price of Brent up a little
more than 9%, and the CRB index is up 4%.
Arguably, two of the most important developments since China's holiday
began is the weakness in the US employment data and, leaving aside the UK, output
of the major economies appeared to slow in August. Although many
market participants have shifted their expectations of a Fed hike out to March
2016, many Fed officials themselves continue to signal the likelihood of a rate
hike before the end of the year.
The Hang Seng China Enterprise Index, which is comprised of Chinese
shares that trade in Hong Kong, has risen by 10.5% since the mainland markets
closed. Recall that in September the Shanghai Composite was
bouncing along the trough that was set in August. It traded between 2983
and 3215. A trendline connecting the June (~5178) and the August (~4006)
high comes in tomorrow near 3192.
Earlier today, China reported that its reserves fell to $3.514 trillion, a
$43.3 bln decline over the course of the month. This was a
somewhat smaller decline than market participants expected. However, if the
PBOC intervened in the forward market, perhaps trying to force a convergence
between the onshore and offshore yuan, as many suspect, the impact in
reserves would not be immediately evident.
Some observers insist that the decline in PBOC reserves also understates the capital outflows because, given the large trade surplus, reserves should
have risen. That may have well been the case previously, but the
liberalization measures weaken this link. Chinese businesses appear to
have greater latitude in converting their foreign currency earnings. Less
of it may be winding up in the PBOC coffers.
The dollar value of China's reserves is impacted by the fluctuations of
the foreign exchange market. The value of China's reserves
peaked last June near $3.993.2 trillion. They have fallen 12% of $479.09
bln since. The euro, for example, has fallen 18.3% since then (through
the end of September). For the purpose of this exercise, if we make a
conservative assumption that 20% of China's reserves were in euros, the
valuation adjustment reduced China's reserves by $147 bln.
This is to say that the depreciation of the euro can account for almost a
third of the decline in the valuation of China's reserves. During
this period, sterling lost 10.5% against the US dollar, the yen fell 15.6%, the
Canadian dollar depreciated by almost 18%, and the Australian dollar fell
23.4%. The valuation drag on China's reserves is frequently not
incorporated in discussions of the decline in China's reserves.
In addition to the evolution of the Chinese economy and stock market,
investors are watching two other developments. First, next month MSCI
will begin a two-step process to include 15 of the most active Chinese ADRs
into their global indices. Half will be included in November and the other half
next Spring. Second, is the IMF's formal decision on the inclusion of the
yuan in the SDR. That decision is expected next month.
Much of China's financial reforms in recent months appears aimed at
facilitating its inclusion into the SDR. We think China's main
interest in being included in the SDR is prestige. It signals the
emergence of China as a global financial power. Some observers think
that if it is included in the SDR, foreign central banks will more likely boost
their yuan reserves, which the IMF estimates to be about 1.1% of global reserve
or roughly $124.6 bln, to triple or quadruple in the next few years. This
seems a bit exaggerated given central banks typically glacial moves.
Moreover, global reserves are unlikely to grow as they have over the past
decade.
The SDR decision requires a 70% majority vote. This means that
the US will not have a veto. In order to block the yuan's inclusion, a
bloc that includes the US, Japan, and several other countries would be
needed. The US position as stated by Obama and Lew is that the US
will not oppose China's inclusion, if it meets the IMF
requirements. The significant exporter criteria is
easily met. The key requirement is whether is its "freely
usable" for international transactions.
It is a judgment call, and we suspect that the odds favor the yuan's
inclusion with a relatively modest weighting to begin.
The new composition of the SDR will be implemented until September
2016. Given that Chinese interest rates are higher than other SDR members
(US, EMU, UK and Japan), it would, on the margin increase the cost of borrowing
from the IMF.
disclaimer
China Returns
Reviewed by Marc Chandler
on
October 07, 2015
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