China: For Global Investors, It’s All About the Currency

Chinese local interest rates rose substantially late last year, and many bond offerings have been canceled, creating financial strain for some Chinese companies.

How should global investors interpret events in China, and what can they expect for early 2017?

Clearly, investors in China are on edge: Over the past few months, the Chinese yuan’s decline and capital outflows have continued apace, while the People’s Bank of China (PBOC) has taken steps to tighten financial conditions. Adding to the nerves, a little over a year ago, a rate hike similar to the one last month by the Federal Reserve precipitated a downward spiral in the yuan and steep declines in equity and bond markets around the world.

In our view, China is still facing what economists call a “trilemma.” It is proving impossible to achieve three goals simultaneously: a stable or fixed foreign exchange rate, free capital movement and an independent monetary policy. Combining tighter financial conditions with this policy trilemma means that the currency will probably remain an “escape valve.”

In the short term, capital outflows will likely continue. Despite China’s ever-tighter restrictions on currency movements, individuals can still convert the equivalent of US$50,000 into foreign currency annually – and they likely will as the yuan declines further. Over the year, our base case is for the yuan to decline against the U.S. dollar by a mid- to high-single-digit percentage. However, we also think the possibility that the PBOC will allow the yuan to float freely, or at least widen its trading band, has increased.

In recent months, the PBOC has shifted its policy focus from promoting growth to reining in the highly leveraged financial sector. As a result, overall liquidity is likely to remain tight and local interest rates are likely to remain elevated at least through early this year.