There is no debate about the direction of Chinese monetary policy, says Eaton Vance's Eric Stein – but the methods and timing of the People's Bank of China's easing are still very much in the air.
The People’s Bank of China (PBOC) cut its reserve requirement ratio (RRR) on 6 March 2016 from 17.5 per cent to 17 per cent.
While this 50 basis point move doesn’t seem like a big deal on a stand-alone basis, we think it is a very important signal from the PBOC that it is willing to ease monetary policy despite the continued capital outflows and pressure on the currency.
We think this is the beginning of a long easing cycle that will see more RRR cuts, falling onshore interbank rates and a weaker currency.
Over the past year, China has seen enormous amounts of capital outflow, which has led to reserves declining from $3.81 trillion to $3.23 trillion at the end of January.
The outflow has come from a variety of sources (corporates, individuals, foreign companies) and for a variety of reasons (hedging foreign liabilities, asset diversification, foreign direct investment outflows).
More interestingly, it appears most of the flow has gone through the current account in the form of over-invoicing (overpaying for imported goods to be able to get more money out of the country) rather than direct financial transactions in the capital account.
The combination of sources, motivations and path of the flows suggests that it will be very hard for Chinese policymakers to stem this outflow by simply closing loopholes in the capital account or trying to punish 'speculators'. These are all real outflows that are unlikely to abate in the current environment.
In the face of these outflows, policymakers have resorted to a mishmash of measures.
They initially devalued/depegged/depreciated (we argue internally the best term for the move) the yuan (CNY) on 11 August 2015, and then proceeded to allow depreciation in fits and starts over the subsequent six months.
Since the beginning of 2015, the currency has depreciated over 5.0 per cent against the US dollar, but has appreciated over 5.0 per cent on a real effective exchange rate basis – the currency has barely moved due to heavy intervention by the PBOC.
This intervention has sucked an enormous amount of liquidity out of the domestic system and has not allowed the PBOC to forcefully ease.
However, as the currency has stabilised over the past month or so, the recent easing by the PBOC may be the sign of things to come; we think China wants to continue with an aggressive monetary easing cycle, but wants to manage this cycle carefully, as it doesn’t want to exacerbate the market forces for CNY depreciation.
The impossible trinity of an open capital account (not fully open in China’s case, but definitely not closing), pegged currency and control over domestic interest rates definitely holds for China and Monday’s RRR cut shows that policymakers are finally willing to put a great emphasis on reducing interest rates.
While we doubt that Chinese policymakers are ready to fully let go of any parts of the trinity, we think they will be forced to 'sacrifice' full control of the currency in order to continue with a monetary easing cycle.
Eric Stein is the co-director of global income at Eaton Vance Investment Managers.
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