Macro Monday China:RMB brings the first surprise in 2017

Markets started the year with a positive note: H-share rose 2.3% in thefirst week of 2017 while A-share gained 1.6%. The offshore CNH marketbrings the first surprise in 2017, as an extremely consensus trade blow up atthe beginning of a year. The surging CNH funding rate along with a weakerUS$ led to a sharp rebound in CNH (Fig 44), which jumped by 2.2% againstUS$ and closed the week at 6.85, the largest weekly gain ever recorded.

    US$50k quota unchanged but with tighter enforcement: Two factors arethe most important behind the movement of RMB: US$ and capital outflowspressure. Assume the change of the dollar this year similar to last year (up4%), the game-changer is whether the PBoC could reduce capital outflows,either through capital controls or reversing the depreciation expectation. Assuch, although the annual US$50k quota remains unchanged in 2017, policymakers decided to tighten enforcement to reduce outflows.

    FX reserves kept falling in Dec: Data released last Saturday show thatChina’s FX reserves dropped by $41bn, to $3.01tn. 12 months ago, bothpolicy-makers and the markets were deeply concerned about capital outflows.

    The good news is that the drop in FX reserves narrowed to US$320bn in 2016,compared with US$513bn in 2015. Three factors are behind the improvement.

    First, tighter capital controls reduced outflows. Second, US$ in 2016 was notas strong as 2015. Third, foreign debt repayment has finished by 2Q16.

    However, the depreciation expectation by domestic residents is still strong.

    Looking ahead, FX reserves would drop below US$3tn in 1Q17. However, thedecline in FX reserves might narrow further in 2017 on tighter capital controls.

    Higher RMB volatility in 2017: Other than capital controls, to ease the onewaydepreciation expectation, the PBoC needs to increase the two-wayvolatility for the Yuan. For instance, in 1H16, when the dollar index droppedfrom 100 to 93, the Yuan was relatively stable against the dollar. It has surelyworsened the one-way depreciation expectation. The sharp swing of the RMBlast week suggests that the PBoC is probably moving towards higher volatilityfor the currency.

    Economic growth ends 2016 stable: The first data in 2017 suggest theChinese economy closed the year on a steady footing. Official NBSmanufacturing PMI released on Jan 1 eased to 51.4 (Prev: 51.7), but this wasstill the second-highest since Jul 2014. New Orders remained robust, andFinished Goods Inventory fell to a 7-year low. Overall, the Chinese economylooks fine at the moment, driven by earnings recovery and inventoryrestocking. The economy is on track to another 6.7% yoy in 4Q16.

    Inflation to edge up in Jan: Due to the different timing of the Chinese NewYear (Jan this year and Feb last year), CPI inflation could jump to above 2.5%in Jan and PPI inflation might be close to 5%. While in Jan 2016 the commonfear was deflation and hard landing, now the concerns are inflation andfinancial risks. Containing financial risk is the top priority for policy-makers,who don’t want to see another market meltdown amid the upcoming politicaltransition. No wonder the PBoC reiterated neutral monetary policy stance lastweek. As such, we expect no rate or RRR cut in 1H17. The bond market isunder pressure on tighter regulation and monetary policy. That said, the risingyields in Wealth Management Products and money market funds (Fig 40)could add to the attractiveness of the Yuan and support the currency.