Should investors care about the declining trend in China’s FX reserves? The answer is no. The decline reflects profound changes in China’s growth model, which, if successful, will actually ensure that the decline continues. In other notable developments the central banks in both Mexico and India surprised the market by being more hawkish than expected, while the central banks in Brazil and Argentina will be rejoicing in lower than expected inflation. As far as Trump and EM is concerned a pattern appears to be emerging: Tweet and retreat!
• China: China’s FX reserves declined to USD 2.998trn in January from USD 3.011trn in December. This marked the first time since 2011 that China’s FX reserves have dropped below USD 3trn. Should we care?
The decline in China’s FX reserves reflects numerous simultaneous developments, including a tougher external environment for Chinese exports, greater Chinese imports, currency valuation effects and net capital outflows via the capital account.
We do not think investors should be overly concerned. In fact, the decline in China’s reserves reflects a profound change in China’s growth model, which, if successful, will actually ensure that the decline continues. This is because China’s new growth model involves greater reliance on domestic demand-led growth, which in turn implies that China will eventually have a current account deficit. Hence, much like the US current account deficit, China’s current account deficit will be financed via the capital account and the RMB will become fully floating. China will eventually no longer need a large stock of FX reserves.
China’s decision to abandon export-led growth in preference to a domestic demand-led growth model is well founded and investors should welcome the change. The whole point of the transition to consumption-led growth is that China wants to be able to grow in a sustainable fashion over the longer-term even when the external environment becomes more hostile. China’s erstwhile export-led growth model is becoming obsolete, because: (a) debt-fuelled consumption demand in the West cannot continue indefinitely; (b) China cannot keep the RMB well below market-determined levels indefinitely; and (c) the world may not always be committed to free trade. In addition, it is doubtful that China would have been able to continue to suppress consumer demand in favor of high forced savings for much longer.
China rightly believes that hyper-easy monetary policies in Western economies will ultimately create inflation, which in turn will undermine real incomes and reduce the scope for consumers to continue to spend as they have before. China also believes that emphasis on stimulus over reform will ultimately weaken Western currencies versus the RMB. And China regards protectionism as a direct threat to Chinese exports and to productivity and trend growth rates in the countries that introduce such policies.
This is why China’s senior leadership started a massive program of economic reform years ago. Clearly, as China’s expectations are slowly being fulfilled, China is increasingly looking to be ahead of the curve compared to most other countries. Still, China’s path is not easy. It is clearly positive that China’s reforms are the right ones. It is also extremely encouraging that, with a 49% savings rate, China has a bright future as a consumption-led economy. However, the challenge China faces is to adjust its enormous economy, which is a bit like turning a Supertanker around. The reforms China is implementing fall into three broad categories:
First, consumption-led growth requires the introduction of completely new instruments of macroeconomic control, notably interest rates. China has now fully liberalized interest rates – local governments and corporates can now finance at market determined interest rates. China is also building a vast municipal bond market, which will become a corner-stone in the monetary transmission mechanism. However, by forcing local governments and corporates to borrow at market determined interest rates, there will be nervousness and even defaults. Investors and consumers alike will delay spending decisions pending evidence that everything will be ok.
Secondly, China has to raise productivity. This is necessary because greater domestic demand has to be accompanied by greater domestic supply in order to maintain overall macroeconomic equilibrium. The key to greater efficiency and higher productivity is price liberalization to allow the market mechanism to allocate capital. China is also focusing on the environment, intellectual property rights and SOE reform. Like interest rates liberalization, however, price liberalization is disruptive.
Finally, China must open its capital account. While not urgent, an open capital account is ultimately necessary, because as consumption rises, China will eventually become a current account deficit country. The current account deficit has to be financed via the capital account. However, capital account liberalization is notoriously tricky in the short term. One obvious problem is that China’s savers are far more ready to invest abroad than foreigners are ready to invest in China, so there is a steady outflow of capital from China to the rest of the world. This problem, however, is temporary. The key to making money flow both ways is to get China’s vast domestic markets properly represented within the major global benchmark indices for stocks and bonds. China is working on this and will succeed. Chinese savers will eventually get their fill of foreign assets and as foreign inflows pick up due to index inclusion the pace of cross-border flows will neutralize.
In other words, we emphatically do not subscribe to the view that the decline in China’s FX reserves is somehow symptomatic of some massive debt problem, an imminent hard landing and rampant capital flight. Predictions of hard landings in China have consistently been wrong and the reason is that such predictions are based on a misdiagnosis of the Chinese situation. China is slowing primarily because of the enormous reform efforts outlined above. Reforms on the scale undertaken in China today are naturally very disruptive, so they contribute directly to slower growth by leading people and businesses to postpone consumption and investment decisions. China has more outstanding bank credit than the average Emerging Markets (EM) country, but this is a consequence of China’s enormous saving rate. China has nearly 200% of GDP deposits in the banks, so it is no wonder that banks lend out more than other countries. But with credit to GDP of 250% the Chinese banking system is clearly not overly leveraged. In contrast Western banks often have loan to deposit rates of 10:1. Rather, China is a high saving, high investment, high growth economy. Besides, most of the lending by Chinese banks has gone into infrastructure, which is likely to have a higher return than the consumer loans that dominate the loan portfolios of Western banks.
The Chinese authorities will manage the capital account to ensure that overall economic stability is preserved during the challenging phase of reforms. Investors should therefore look beyond the immediate uncertainties towards the longer-term and, in our view, steadily allocate to China. The determined efforts to develop new growth drivers will stand China in good stead as economic policies in Western economies become ever more self-serving. By the middle of this century we expect China’s GDP to be about four times larger than US GDP. As China’s savings rate steadily declines over the same period, consumption will grow even faster than GDP. It is clearly in the interest of exporting countries around the world to orient themselves towards China, particularly because China will open up as the US becomes more insular.
Longer-term, the RMB will become ever more widespread as a global reserve currency and eventually it will replace the Dollar as the most important global reserve currency and hence China will need fewer reserves. China’s government bonds will also become the dominant global benchmark for fixed income, which means that institutional investors the world over will have Chinese government bonds as core allocations (resulting in further inflows to China).
The US has stood as a beacon of free markets and globalization for many decades and investors are understandably heavily exposed to US markets. But as China steadily becomes more investor-friendly and grows in economic influence it follows that China will need fewer FX reserves. This decline is simply a real-time manifestation of positive fundamental changes that, eventually, will put China in a position, where, like the US, it barely needs reserves at all.
Jan Dehn is the head of research at Ashmore Group Plc, a specialist emerging markets asset manager with over US$ 50 billion under management.