- China’s current account is responsible for a substantial portion of the reserve decline
- caused by unfavourable changes in export & import conversion ratios and invoicing decisions
- current account contribution to reserves even more volatile than the capital account
- the acceptance of CNY/CNH as an invoicing currency in Asia is at risk as trade partners require US $ payments
- further pressure on EM vendor financing mechanism
As another month has come to a close, it’s almost time again to recycle the competitive devaluation and capital flight stories published over the last six months. Although the declining reserve position last year was reported widely, the mechanism of the various flows and their consequences have often been left unexplored.
The “State Administration of Foreign Exchange” (SAFE) provides a relatively, at least by Chinese standards, extensive dataset which presents the FX buying and selling by Chinese Banks on the one hand and all other non-financial actors on the other hand. Banks usually only operate as pass-through institutions and rarely alter their FX position by much; they occasionally absorb flows as during August last year when they (willingly?) sold dollars to non-financial actors to accommodate outflows.
[Chart 1] shows the cumulative dollar demand and supply by Chinese non-financial actors in 2015. All values are in bn CNY equivalents even though the reference unit is foreign currency i.e. mostly US dollars. The single categories aren’t netted yet so that gross quantities are observable.
As an example, exports of goods contributed 7354bn CNY or ~1160 bn US $ to China’s reserve position. In other words, Chinese corporations sold goods to other countries and received an amount X as payment in foreign currency (FC)1 and decided to exchange all/something/nothing, say Y, of their FC received for local currency (LC) at the PBoC. During 2015, Y equaled said 7354bn CNY. A similar amount of FC, 7612bn CNY, was demanded by Chinese corporations to pay for imports.
The “Net” category is the resultant flow effect on the PBoC’s foreign exchange position. The drawdown of 3248 bn CNY during 2015 divided by the average USD/CNY rate (~6.25), yields a reserve drawdown close to the frequently cited number of 500 bn $.
The vast bars in the export & import of goods section demonstrate the importance of gross trade flows. They outshine capital account items with ease. The netted numbers, see [Chart 2], by category for 2015, therefore somewhat understate the importance of current account transactions on foreign exchange reserves as small percentage changes in FC demand or supply in these can easily overwhelm other categories.
By only looking at the above data, the solution seems simple: cut the services deficit and clamp down on the residual outflow category2. The problem with this is that even though the two categories worsened in 2015 vs 2014, both were already quite negative before.
The principal difference in 2015 was the sharp decline in FC brought in via the net exports of goods category while during the same period the current account surplus, a bit counterintuitively, widened.
Export & Import conversion
The current account is primarily intended to measure the difference between goods & services purchased and sold. It does however not offer insight into the invoicing currency. Thus, the amount of goods/services bought and sold alone is not sufficient to describe the effect on reserves. The missing piece is the share of exports receipts that is translated into LC and the share of imports that can be paid in LC; i.e export & import conversion ratios.
In the chart above the blue line shows what percentage of FC export proceeds are swapped into LC. During Q4/2015, 0.52 $ were exchanged for LC for every dollar of exports. Similarly (in red), during the same time frame 75% of imports had to be/were paid in FC.
The significance of the up move in the import conversion ratio and the down move in the export conversion ratio cannot be overstated. Despite the increased current account surplus during 2015, reserves were used up to enable China’s trade operations. The swings in the conversion ratios are the primary driver of reserve accumulation. Despite a relatively steady current account surplus post GFC, the below data displays the volatile contribution current account transactions had on the reserve position. Even during 2015 when the attention was squarely focused on capital account transactions, the current account was at least as much a culprit as the capital account.
Quite rationally, as [Chart 4] shows, the direction of conversion ratios varies with phases of CNY appreciation and depreciation expectations, very similar to “pure” capital account flows. Given the swings in the current account contribution to reserves, it may be appropriate to mentally classify them somewhere in the middle of the spectrum with *regular* current account transactions (solely conducted in the seller’s currency) on one end and regular capital account transactions on the other. The effect is equivalent to the latter even though it is rather the passive allocation of profit attained in the global real economy vs mostly financial profit expectations which drive the capital account.
In appreciation mode, Chinese actors want to swap FC into LC to benefit from (expected) future FX gains, while foreign countries which export to China are willing to accept CNY as payment. Even if they don’t believe in the appreciation themselves, the fervent appreciation belief of others provides ample liquidity to exit later and thus accept payment in CNY in the present. At the moment, given depreciation pressures, the above processes occur in reverse order. Exporters keep more of their FC receipts and other countries demand payment in FC as the acceptance of CNY payment in the contemporary skewed environment would be akin to selling a put option without demanding an adequate premium.
Since these conversion processes aren’t affected by how the proceeds are eventually used, they shouldn’t be expected to stop naturally with the passage of time. This is relevant insofar as the supposed assumption that the export conversion ratio will turn up again when proceeds were used to pay down FC debt is hardly conclusive. Of course, changes in sentiment due to debt repayment could push upward pressure on the export conversion ratio but there is no scientific law that will become operative once debt has been paid down.
While the accumulation of FC has been flagged on some occasions, the change in the import conversion ratio, not only due to a larger percentage move, seems more important in an international liquidity context. The decision by exporters to retain FC receipts is entirely up to them. On the contrary, the decision of the invoicing currency whenever Chinese corporations import goods lies mostly with foreign countries, as they take on the FX risk and might entail losses if further CNY weakness materializes.
The move higher in the import conversion ratio can consequently be interpreted as other countries getting more cautious accepting CNY.
Why is this important? As is well known, many EMs borrowed in dollars due to interest rate differentials & expectations of local currency appreciation and now face pressure due to a stronger dollar and rising US interest rates. The problem, well covered by the BIS and the FTAV crew, is that this credit was oftentimes funded by reserve accumulating EMs (vendor financing) with very favorable terms, was frequently geopolitically motivated and thus came with low/too low? risk premiums attached. Due to the declining reserves in many EMs, the Eurodollar market for the emerging world started to experience pressures as the dollars either go home (via imports) or are transferred to private actors to delever or diversify their assets in a world without EM currency upside pressures.
China is at the center of the vendor financing mechanism as its companies got access to cheap dollar credit and it used its reserves and the-always-appreciating-CNY to provide funding to other, more risky, places (Latin America & Silk Road).
All this wouldn’t be too concerning if the RMB already was a seasoned currency with solid official and private backing. The SDR inclusion may be the first step for further official flows but private institutions don’t seem too eager to push money into China at the moment.
If the elevated level in the import conversion ratio persists, the prospect of the RMB as a serious alternative invoicing currency to the dollar in Asia declines. In this case, EM Asia first lost easy Eurodollar liquidity access and subsequently decided not to revert to the second best alternative, CNY, worsening liquidity conditions further.
Should the notion of a vendor financing mechanism be accurate, the insistence by other countries to receive $ instead of CNY accelerates the drawdown of reserves and amplifies the pressure on the system in its current form.
The above paragraphs may paint an overly pessimistic picture and are more of a worst case scenario than a forecast. The situation is unendingly reflexive and riddled with path dependencies, complicating the formulation of timely directional market calls. As shown, a big part of the pressure on the Chinese currency was exerted by corporates and outside countries’ varying future expectation of the CNY path. These corporate flows could in theory be reversed or neutralized more easily, when depreciation expectations were dampened, compared to one-way-flows like embezzled funds fleeing due to the anti-corruption campaign. In case the conversion ratios normalized and the PBoC & Co showed improved communication skills, short-sellers may decide to cover and a medium term equilibrium could be reached.
For the moment though markets seem locked in depreciation mode and the question arises what the next moves the Chinese authorities could take, if further depreciation pressure mount, would be. Some more or less realistic, fragmentary thoughts:
a) Increase the export conversion ratio back to its 2010-2013 average of 70%. Combine the Chinese leadership’s far-reaching power with some nationalist “profits-must-be-repatriated-to-Middle-Kingdom” and increasing the export conversion ratio by 20% would result in 533bn $ extra inflows assuming unchanged export numbers. Regulations of this type wouldn’t be new for China. Before the current framework was introduced, the system moved from a full FC surrender regime at first to a quota based system later before full discretion was granted.
b) Lower the import conversion ratio. Rather more difficult than a). Rhetoric rather useless. Could use quasi-status as monopsonist in some goods to force partial acceptance of CNY. No long-term solution but temporary method to break positive feedback loop.
c) Travel is the current account item showing the biggest change over the last few years following the CNY-REER appreciation. Unfortunately, the conversion ratio of this category is likely close to one as hotels in Tokyo or shops in Seoul aren’t accidentally waiting to accumulate CNH. Levying charges on or even restricting outbound tourism wouldn’t boost national sentiment and are thus likely lower on the to-do list. More realistically, elevated scrutiny of larger/trophy purchases abroad could dampen the zeal of wealthy citizens travelling abroad.
d) Suspend ODI to neutralize the fall in inbound FDI.
1. This simplification isn’t entirely correct as some payments to China by other countries for imports is now settled in CNY/CNH, enabled by the growth from 2010-2014 of offshore CNH trading hubs. As CNH trade settlement is rather small and relatively static over shorter periods, the disregard shouldn’t weaken the main arguments discussed below. »