Chinese Foreign reserve balances spell relief

Source: IMF

One ongoing debate between market participants has been whether recent policy measures provided the necessary response to Chinese market volatility earlier this, or whether the latter is indicative of a massive policy misstep.

Several Australian fund managers have voiced to us the concern that the latter might be all too likely, and have used the concern to justify remaining on the sidelines with regard to China.

However, recent Chinese foreign reserve data tell a different story – that China’s interventions in the stock and foreign exchange markets might have been more effective at managing market expectations than at first they seemed, which would indicate that authorities still have a firm hand on the policy rudder.

Chart1

Chart 1: China foreign exchange reserves, Change month-on-month (USD bns)

Effective policy credibility means managing expectations

One key measure of policy credibility often employed in economic models is that of using market expectations to work in the desired policy’s favour. For example, a central bank’s effective management of inflation (via controlling the supply of money) is dependent on keeping inflation expectations in check today such that prices do not escalate tomorrow. For China, for whom autonomous central bank control of money supply is not available, allaying the impact of market gyrations relies on setting market expectations by other means. China must influence market expectations such that government intervention (selling foreign reserves, buying the Yuan and equities) appears sufficient to offset the effects of volatile outflows from the market and thus keep steep market declines from turning into wholesale capital flight.

In the context of recent Chinese market volatility, a large contingent of market players, upon observing official interventions in the stock and currency markets, estimated foreign exchange interventions to have been massive in size. Enough market participants expected draw-downs on Chinese foreign reserves for instance to have totaled up to $200bn over the month of August to be cited in mainstream financial media. Logically, at least some of our collective fears should be assuaged by foreign exchange reserve data subsequently released, which show more modest actual drawdowns of a much more modest 93bn (see Chart 1). More recently, a modest rise in FX reserves in October (the first in six months) led market watchers around the globe to conclude with relief that the period of volatility-led interventions had come to a hiatus.

The ability of Chinese officials to manage expectations as to curtail market speculation and thus volatility is one indicator of effective policymaking.

SDR, redux

Alongside China’s move toward greater transparency, to effect partial IMF-stipulated disclosure of composition of foreign reserve (COFER) data, evidence of effective policymaking was almost surely one factor in the IMF’s very recent assessment that the RMB meets requirements to be deemed a “freely usable” currency, thus compelling staff to propose renminbi inclusion in the Special Drawing Rights basket to its Executive Board on November 30.

As such, inclusion of the RMB within the SDR at the IMF’s review might lend China an official “seal of approval” of sorts – supportive of the view that Chinese officials retain policy credibility even despite recent volatility. If so, this in turn may further dispel speculative downward pressures on Chinese stock as well as the RMB, both unhelpful to further capital account deregulation.

SDR inclusion on November 30 may once again provide a larger-than-life fillip to the renminbi’s global investment appeal.

Chart2

Chart 2: IMF COFER data – allocated reserves including China (partial disclosure) in Q2 2015