Renminbi Bond Market

Introduction

A nation’s bond market plays one of the most important roles in the economy’s financial intermediation, which according to the IMF (WP/05/57):

As we have argued, prudent management of government debt is important to safeguard fragile domestic banking systems. But financial development in the long run benefits greatly from moving beyond a purely bank-based system to include not only a stock market but also a long-term private bond market.

The entrenching role of debt has gone unnoticed, like the air we breathe, good quality corporate debt has been taken for granted. Society is now gasping for a breath of fresh air. The subprime mortgage scandal in 2007-2008 was an opportunity to recapitalize the financial system and get to grips with the extent to which we were geared. Although equity valuations around the world plummeted amounting the loss of confidence, we rolled over on the opportunity to reform and consequently doubled-down on leverage.

So the question needs to be asked: what induced the introduction of more debt? Central bankers, in the interest of our welfare-maximizing state, purported to perform large-scale asset purchases, also known as ‘Quantitative Easing’, results of which can only be established ex-post in the coming years.

Recent literature recognizes the key role debt plays in 21st century financial intermediation. Globalization means trade and money flow seamlessly cross borders and time zones, resulting in a global economy which never rests. As a result, contagion will continue to be one of the greatest risk management tools the government of any developed nation needs to maintain in order to prevent spill over and effects from capital flight.

A major risk management tool of advanced economies is debt, specifically government bonds.

Government bonds are the backbone to society: an asset class which institutional investors hold in the nation’s currency – the bond is a principal investment and pays coupon payments in the denominated currency over the term of issuance. Furthermore, government bonds are riskless so long as holders believe the probability a government will unwillingly default on its obligations is incomprehensible.

This can only be held under two assumptions: Firstly, future cash flows from tax revenue can maintain coupon payments and secondly, more debt can be raised to pay off current debt obligations. This means government debt serves and gets treated as collateral to financial intermediation.

Further from the IMF working paper:

A government debt market does this first by putting in place a basic financial infrastructure including laws, institutions, products, services, repo and derivatives markets, and second by playing a role as an informational benchmark. A single private issuer of securities would never be of sufficient size to generate a complete yield curve, and his securities would not be nominally riskless because only the government has the power to print domestic currency.

If a complete yield curve depends wholly on a deep and liquid bond market, the speed by which a bond market is developed is most important. Underwriting fees of investment banking arms move in-line with the rate of bond and equity market development. So long as more debt and equity is issued or restructured, underwriting fees will result. Some would consider this a conflict of interest between the profit-seeking of investment banks and the social stability of financial development.

Let’s then consider the pace of bond market development, from a 2016 Standard & Poor’s Report,

The world has amassed debt at a faster pace than income growth since the 2008-2009 financial crisis. That pace contrasts greatly between developed and developing economies… Globally, the increase in debt has outstripped income growth, with Asia and Latin America far outpacing Europe’s and North America’s low rates. In terms of corporate debt, the very high borrowing of Chinese and Hong Kong corporates amid China’s economic slowdown poses a prominent risk. A less obvious risk is the increased concentration of U.S. corporate debt among ‘B’ or lower speculative-grade issuers.

In fact, the prospect of rising defaults in China is only one of the two largest risks to global corporate credit, as the surge in leveraged finance in the US is the second, according to S&P Rating Services. Having reached 10.6% in 2010, China’s economic growth has contracted consistently year-on-year, registering 6.9% in 2015. Nominal GDP growth is one proxy for debt demand.

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The S&P project $71 trillion of global corporate debt to be outstanding in 2019. This resulted from a $57 trillion demand for corporate debt from 2015 to 2019, of which $37 trillion was refinancing and $20 trillion new debt. This projection is a 4% drop from last year and projects $11.4 trillion of debt being issued each year through 2019.

Of the $71 trillion S&P project to be outstanding, Chinese corporate debt is expected to represent 40% or $28.4 trillion. This suggests China’s “capitalism with Chinese characteristics” relies upon corporate debt as the fuel for its economic growth, at least numerically. In fact, China’s corporate debt now stands 8x the size of Chinese government debt and is also the largest in the world.

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To put into perspective, the compound annual growth rate of corporate debt issuance in the U.S. has been in the region of 3-4% per year – a textbook example of the rate at which a bond market should be developed (depicted below).

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The S&P note that the trend of issuance has been twofold. Firstly, investment grade (greater than BBB-) issuers in the US have been issuing cheap debt and then hoarding the proceeds as cash offshore. For example, Apple’s cash position amounted to nearly 10% of corporate America’s cash, according to the Financial Times. The cash position of non-financial companies in the US amounted to $1.73 trillion, according to Moody’s, but nearly two-thirds of this is left abroad due to taxation. Secondly, quantitative easing by the Fed has allowed speculative grade (lower than BBB-) issuers to pay down previously held debt obligations by issuing lower cost debt. In this case, the S&P raises concern over the high indebtedness of US corporates against US leveraged finance borrowers.

In contrast to the US, the Chinese Renminbi bond market remains in infancy, despite its vast size. Analysts have voiced their concerns on the divergence between the rate of economic growth and corporate bond issuance in China. Corporate debt issuance has climbed in the last five years while the rate of economic growth in China slowed to its lowest pace in 25 years, albeit still standing 3-4x greater than the U.S. and most of Europe. Analysts are concerned with the ability to repay debt obligations, specifically if corporate earnings aren’t able to keep up with debt service payments, a vicious cycle of defaults would begin. In this case, an intervention by the Chinese authorities would be the lender of last resort, preventing contagion to Chinese equity markets and spilling over to global valuations.

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The above graph depicts the growth of bonds outstanding in China (corporate as orange and government as blue) against the year-on-year growth rate of corporate bonds. The issuance trend grew considerably until just after the subprime mortgage scandal, after which the growth rate has moderated into stable double-digit territory. China’s bond market now stands as the 3rd largest in the world, following the U.S. and Japan.

What is the driving force for bond market development? In order to diversify the risks associated with and to establish a modern financial system, the Chinese government has recognized that a bond market alleviates the pressure on Chinese companies from being restricted to equity raising and bank loan financing. Bond issuance effectively substitutes away the risk from the banking system and into investors hands, currently domestically but eventually internationally.

However, the rapid debt growth, opacity of risk and pricing, high debt-to-GDP, and uncertainty surrounding Chinese equity markets continue to pose as significant risks. Another concern surrounds the role state-owned enterprises continue to play in the Chinese economy. According to the Asian Development Bank (table below), the top 30 issuers of corporate bonds in China are either state-owned enterprises are strongly connected to the Chinese government via consolidated ownership:

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These 30 issuers compromise 40.8% of the total corporate bond market, and since these issuers are either state-owned enterprises (SOEs) or connected to the Chinese government, the state must continue to be invested in the financial stability of the economy. This is of concern since SOEs tend to show credit metrics about half as strong as non-SOE peers, according to the S&P. Diversification of ownership is necessary in order to spread the risk among participants of the financial system.

The table below shows the large state-concentration of holdings in Chinese government bonds and corporate bonds, albeit the ownership division is more diversified for Chinese corporate bonds:

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Financial liberalization leads to favourable conditions for bond issuance

If financial disintermediation is set to increase in China, leverage via the bond market is set to replace the share of funding currently necessitated by bank loan financing. The Fung Global Institute (FGI) expects the bond market to necessitate bank loan financing for the following four reasons:

  1. Basel III – assuming the framework is fully embraced by Chinese banking regulators, commercial banks will face more stringent capital requirements, leading bond market growth to exceed bank lending.
  2. Restrictions on lending – new policy measures will restrict bank and shadow bank lending to local government financing vehicles (LGFVs), leaving municipal bonds as the only measure by which financing can be maintained. The Chinese Budget Law has formally legalized bond issuance by municipal governments. This allows current LGFVs to swap their bank and shadow banking obligations with newly issued municipal debt. An estimated RMB1 trillion of municipal bonds is expected to be issued under the swap scheme.
  3. Asset-backed securitization – ABS enables banks to offload parts of their loan portfolio to investors in the form of bonds, made available by new regulatory frameworks. ABS issuance has risen eight-fold over the past two years, according to FGI.
  4. Small and medium size enterprises – financial deregulation will shift attention towards SMEs in order for banks to maintain their net interest margins. This means that existing blue chip companies will continue to raise capital via debt issuance, thereby expanding investment-grade debt in the market and facilitate a large enough bond market that will encourage issuance of high-yield greater-risk bond issuance by SMEs.

Greater issuance in China’s bond market is being constrained by the following four non-exhaustive reasons:

  1. Ownership profile: Increased growth of the bond market requires a diversity of ownership, thereby spreading risk. Chinese banks are not only the biggest underwriters of bonds, outside the treasury segment, but also the dominant investor in the domestic bond market.
  2. Moral hazard: The issuers and holders of corporate and government bonds in China are, in a majority, directly or effectively linked to the government.
  3. Cornered market: The bond market of China is cornered. Commercial banks combine to hold 70% of onshore bonds, while non-bank institutions (insurance, pension and bond funds) hold a remaining 23%. This is a cause for concern regarding liquidity of the bond market, as non-bank institutions tend to be the most active participants. The table below is drawn from the FGI working paper.
  4. Convoluted regulation: There are multiple government organizations which regulated China’s bond market. This is a hindrance to bond market growth. Five regulators oversee the six types of bond instruments traded onshore and offshore. A lack of clear leadership and transparency makes regulation convoluted.

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There are five regulatory organizations in China:

  1. State Council Securities Commission is the main regulatory authority for capital markets in China, whereas the China Securities Regulatory Commission (CSRC) vets issuance of corporate bonds by publicly listed companies in China.
  2. National Development Reform Commission (NDRC) approves and regulates issuance of debt instruments of non-listed companies. These are normally SOEs.
  3. People’s Bank of China (PBoC) is the central bank, regulating interbank lending and bond markets. The PBoC approves the sale of short-term corporate bills and commercial paper issued in the interbank over-the-counter market.
  4. China Banking Regulatory Commission (CBRC) jointly approves with the PBoC bond issuance by commercial banks, including securitization of financial assets and bank guarantees for corporate debts.
  5. Ministry of Finance (MoF) is in charge of scheduling public borrowings – approving onshore bond offerings by foreign institutions, together with the State Administration of Foreign Exchange (SAFE) in approving the Qualified Foreign Institutional Investor (QFII) scheme.

Once issued, the secondary bond market in China is relatively simple: two exchanges (Shanghai and Shenzhen), the OTC market, and the interbank market (regulated by the PBoC). For comparison, Hong Kong has three primary regulators with clearly defined roles:

  1. Hong Kong Monetary Authority (HKMA) is the de facto central bank and manages the issuance of exchange traded fund bills and notes (EFBNs). The HKMA Central Money Markets Unit (CMU) is the central securities depository unit that provides clearing, settlement and custodian services for EFBNs.
  2. Hong Kong Exchanges & Clearing (HKEx) is the exchange and clearing system that facilitates the dealing in both EFBNs and listed government and corporate debt securities, which are traded OTC.
  3. Securities and Futures Commission (SFC) is the statutory body that oversees the enforcement of the Securities and Futures Ordinance (SFO), the law governing securities and futures markets.

Not only is the regulation of Chinese bond markets more convoluted than that of Hong Kong, market structure is also divided, for example: the Chinese government bond (CGB) benchmark yield curve is divided with the tenor under one year with de facto PBoC supervision, and with tenor after one year with de facto MoF supervision.

The Federal Reserve Bank of New York staff report that a divided regulation and structure can hinder bond market development but also suggested that, in the case of China’s onshore bond market,

Coupon-bearing securities, higher coupon rates, larger issuer sizes, longer maturities, and more recent issuance are all associated with increased trading activity.

Increased trading activity leads to greater market liquidity, addressed later on. More importantly, a more efficient regulatory structure and diversification of bond ownership will enhance the development of a more efficient benchmark yield curve, thereby facilitating greater trading volume and deepening bond market liquidity.

Table 2 below is a projection of bond market issuance in China through 2020, by FGI. The projected compound annual growth rate is a healthy 12% and expects the bond market to double in size from RMB28.7 trillion in 2014 to RMB56.7 trillion in 2020. As noted previously, nominal GDP is a proxy for bond issuance and FGI expect China’s nominal GDP to grow through 2020 at an annualized rate of 10%. Given bank loan growth is a projected 8% and bond issuance is projected to be greater than bank loan growth, the additional bond issuance provides for the 2% shortfall of bank loan growth to nominal GDP.

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If the projections above are correct, doubling the size of China’s bond market could help absorb potential shocks resulting from cross-border capital flows, assuming China begins to open its capital account. This would provide the PBoC with another cushion against Trilemma, known as the choice of two of the following three: a fixed exchange rate, free capital movement (absent of capital controls) and independent monetary policy.

A developed bond market provides tools to the central bank in carrying out monetary policy, whether it be conventional or unconventional. The PBoC utilizes monetary policy tools similar to that of the US Federal Reserve, albeit a tiny fraction of the US in terms of trading activity:

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Given market size and liquidity are positively related, a more developed bond market would establish stable benchmark rates from which hedging tools could be established and thus support further corporate and municipal bond growth along the way. Since the 2008 financial crisis, risk management has become a major concern to market participants – a key issue central to the development of Hong Kong Exchanges and Clearing Limited, according to its Chairman, Charles Li. Exchanges and clearing houses in Europe have been undergoing M&A as they have felt the pressure to evolve and innovate.

As liquidity is one of the main proponents for greater bond market issuance in China, let us briefly explore the theory behind the function of liquidity of a bond market. Market liquidity is defined as,

The ability of buyers and sellers of securities to transact efficiently and is measured by the speed with which large purchases and sales can be executed and the transaction costs incurred in doing so.

To put this in context, price volatility is dependent on market liquidity, such that transaction volume can lead to big price swings if trading volume in the market is thin. The optimal amount of market liquidity is somewhat arbitrary and depends on the type of market and product being traded. Structurally, if the size of a bond market were to grow 5% per year, would transaction volumes need to increase concurrently or by a greater or smaller percentage? The answer is arbitrary.

In the aftermath of the subprime mortgage scandal, the Federal Reserve, led by Chairman Ben Bernanke, decided to boost transaction volume in the bond market, through quantitative easing, This was purported to provide liquidity. However, quantitative easing is only possible if a nation’s bond market is developed and deep (i.e. large) enough to provide the liquidity pool from which market participants can diversify risk. As a result, bond risk premia was contained as the spread between corporate and government bond prices remained close. In fact, there is empirical evidence of the increasing divide between equity risk premium and the risk-free rate:

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Large transaction volumes, fed by the Fed, propped up corporate bond prices and reduced the risk premium. So you ask, why is risk premium so important? Risk premium is modelled into equity valuations, specifically any capital asset pricing model and discounted cash flow valuation. The greater the risk premium, the greater the ‘discount’ on future cash flows, resulting in lower equity valuations today – dragging on stock prices during market turmoil.

In the US, regulation is viewed as a strain on bond market liquidity as dealers, acting as market makers, have found it increasingly expensive and difficult to hold inventories. This is shown in the below graph as net dealer position in corporate bonds (red line) have dropped since the financial crisis began in 2007, and the volume of government bonds (blue line) has increased. That said, a reason for the divergence in net dealer position could be due to the open market operations of the Federal Reserve in buying corporate bonds for US treasuries.

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Market liquidity is a key component to dealer commission – derived from the bid/ask spread of the bond trade – whereby the commission generated reflects the transaction cost associated with holding and dealing in bonds. Thus, reduced bond inventories will likely cause a reduction in liquidity and as such, dealers command a discount on the bid price and a premium on the ask price, causing the bid/ask spread to widen. This leads to reduced liquidity, thereby making capital raising by corporates more expensive as investors demand a higher yield to offset the associated risk with lower liquidity. This compensation in yield could be thought of as the increased transaction cost.

Liquidity of the bond market seeks to raise the efficiency of the pricing mechanism. China has acknowledged the need for greater transparency, a key factor in transparent pricing. In 2015, the Chinese government established a debt ceiling of RMB16 trillion and is set to include local government debt balances in the annual budget management. Furthermore, the municipal bond market was officially launched in 2015, leading to coordination between the PBoC, MoF and CBRC on administrative rules regulating the issuance and budgetary conditions of municipal bond issuance. As a result, the average financing cost to LGFVs was reduced from 10% to 3.5%, and the average life of debt was more than doubled from 3 years to 6.5 years.

Financial liberalization can lead to greater bond issuance in China, but has this been performed for the right reasons? According to DB research:

  1. The CSRC has relaxed restrictions on to all issuers of corporate bonds, both financial and non-financial, and relaxed administrative controls over the refinancing by property developers. This is concerning since property developers accounted for 43% of outstanding corporate bond issuance in 2015.
  2. The NDRC now allows the use of corporate bond proceeds to repay bank loans, within new limits. The ability to repay bank loans has been closely watched by participants as non-performing loan ratios (addressed below) is centre of attention to the Financial Times.
  3. The NDRC has promoted issuance of enterprise bonds to support infrastructure projects.  Enterprise bonds account for 6% of the bond market outstanding.
  4. The NDRC has simplified the approval process of enterprise bond issuance and relaxed credit rating requirements for issuers from AAA-rated to AA-rated.
  5. The PBoC has simplified the registration of ABS issuance. ABS account for 1% of the bond market outstanding.
  6. The PBoC cut its policy rate and reduced the required reserve ratio (RRR) of banks in 2015.

The pace of bond issuance: the numbers

Since the subprime mortgage crisis, the primary narrative consuming global markets has been anything related to China. Equity valuations around the world have been cushioned on the confidence stemming from healthy demand for China’s export-driven economy, which has experienced double-digit growth in the last decade. However, eyes now turn to the pace of bond market development, which has grown from being virtually non-existent to one of the world’s largest.

It can be said that a nation’s government bond is the only way by which global institutional investors can establish a safe holding in the bond-denominated currency. This has been a key motivation for the liberalization of the Renminbi. It would be difficult to justify a case against the existence of a bond market with a size relevant to complement the size of its equity market.

However, the speed and pace of bond market development could provide instability to the already fragile state-capitalist nation. China’s bond market expanded at its fastest speed in 2015 and according to Deutsche Bank markets research,

We believe financial deepening in the RMB bond market will accelerate in 2016 and with China gradually liberalizing bond market access by foreign investors and borrowers, the RMB bond market is an emerging global asset class to facilitate investment diversification and financing demands on a global scale.

While the size of China’s bond market expanded at its fastest pace in 2015, did market structure and regulatory development compliment the expansion?

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The pace of bond market expansion in China, according to Deutsche Bank research:

  • Outstanding size of fixed income market reached RMB48.37 trillion in 2015, up 34% from 2014.
  • Gross supply to fixed income market was RMB23 trillion in 2015, up from RMB12.5 trillion in 2014, accounted for by bonds of non-financial corporations (25%), interbank CDs (23%), financial bonds (18.6%), municipal bonds (16.7%), and CGBs (9.2%).
  • Net supply (negating for refinancing) was RMB12.4 trillion in 2015, of which 38% was from CGBs (central government bond supply was 9% and municipal bond supply was 29%).
  • Net issuance in 2015 of interbank CDs was 404%, municipal bonds was 315%, corporate bonds was 111%, and ABS was 102% from 2014.
  • Gross supply of municipal bonds was RMB3.8 trillion in 2015, lifting the size of the municipal bond market to RMB4.83 trillion in 2015 – a quadrupling of the market size – accounting for 10% of the RMB onshore bond market.
  • Gross supply to corporate credit market was RMB7.27 trillion in 2015, amounting to around 31% of total gross supply in 2015. The corporate credit market includes enterprise bonds, corporate bonds, medium-term notes, commercial papers, convertible bonds, privately placed bonds.

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The corporate bond market increasingly serves customers who traditionally looked to the shadow banking system for financing. Increased corporate bond issuance points to the success of financial liberalization and greater access to the corporate bond market has resulted from policy reform. Direct financing as a share of aggregate social financing rose to 16.5% in 2015, up from 14.5% in 2014 and 8.9% in 2009. Given the steady rate of new loan growth, the rising share of direct bond financing can be attributed to the shift away from shadow banking.

Confidence on China’s bond market growth points to the Renminbi interest rate term structure as a key indicator. Money market volatility has been reduced on the back of three structural changes: (i) removal of the 75% ceiling of loan-deposit-ratio, (ii) cut of 250bps in the required reserve ratio, and (iii) establishment of a short-term interest rate corridor by the PBoC. This helped increase liquidity in the bond market and assisted the development of the onshore RMB interest rate, a rate crucial to monetary policy transmission and a proxy to establish reliable pricing in the forward market for interest rate and credit.

However, increased liquidity does not necessitate lower volatility:

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The bond market has yet to establish stability in the long-term yield of Chinese government bonds. In 2015, the 10-year CGB fluctuated between 2.85-3.5%, a reasonable range:

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But the realized volatility averaged 21%, higher than any point between 2009-2014. This could have been due to the following factors:

  1. Excess volatility in equity markets spilling over into bond markets, as Chinese investors learn how to diversify into safe-haven assets.
  2. Better liquidity conditions resulted in higher turnover on 10-year CGBs, further boosting trading activities between underlying cash and 10-year CGB futures.
  3. Greater uncertainty on long-term CGBs due to supply risk of outdated municipal bonds.
  4. Greater uncertainty over the outlook on China’s economic growth. Repayment risk increases if economic conditions are unfavourable, leading to monetary policy contraction and/or austerity measures.
  5. Structurally, there is a lack of policy tools to guide the 10-year CGB, the long-term risk free rate in China.
  6. Volatility in long-term US treasuries will have had a margin impact on 10-year CGB, given the RMB is fixed to the USD and the volume of US treasuries the Chinese government own.

Then why is the onshore RMB interest rate so important to bond market development? Interest rate liberalization. This will develop an efficient interest rate and bond market, establishing the foundation for interest rate pricing and secure the place of a risk-free yield term structure.

The MoF has increased transparency by publishing the 1- to 10-year CGB yield term structure and enhanced the CGB yield curve by adding three factors: (i) monthly 6-month T-bill auction, (ii) weekly 3-month T-bill auction, and (iii) the MoF published 3M and 6M T-bill yields on its website and extended the CGB benchmark yield term structure from 3M up to 10-years.

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Conclusion: China needs to shift from Shadow to Traditional Banking

Can China afford to cushion the blow of a credit crisis? Yes, thanks to household savings. It is a well-known fact that China has one of the highest savings rates in the world – household savings are 35-40% of income and gross national savings are 45-50% of GDP – however this is mostly attributable to capital control, at least in recent years. As a result, shadow banking is the location of funds, by the way of trust and wealth management products, entrusted loans, and bankers’ acceptance bills.

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Shadow banking has played a key role in providing funding to riskier projects, acting as an alternative source of funding to real estate developers and LGFVs who have been responsible for infrastructure and property development – contributing to China’s GDP.

Observers worry that leverage is being increased at a pace greater than economic growth, resulting in diminishing nominal returns. The credit cycle requires corporations to maintain their obligations in the face of slowing economic growth. An indicator of repayment risk development is the non-performing loan (NPL) ratio and total social financing in China. While there is regulatory relief on NPLs, the size of NPLs could become large enough that banks stop lending to each other, thereby inducing a credit crisis.

However, greatest concern is on the pace of capital flight out of China and the rate of FX reserve depletion since mid-2014. More worryingly, it could be said that the pace of capital outflow has been understated due to the a large current account of nearly US$300 billion and received direct investment flows of US$250 billion, according to Barclays Cross Asset Research.

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While estimating the size of capital outflows is extremely difficult, since estimates are subject to definitional and measurement issues, the effect can be put in context: (a) China capital outflows are significantly greater than the FX reserve decline; (b) large outflows have been a persistent feature of the Chinese financial decline since early 2015, with the pace of outflow picking up over the recent three months; and (c) reserves are declining at more than US$1 trillion per year – reserves grew US$400 billion in 2013, contracted US$24 billion and US$483 billion in 2014 and 2015.

Who is responsible? Loose monetary policy of the PBoC, according to Barclays Research:

While uncertainty over the currency presumably played a role in rising capital flight, we think the bigger reason is rooted in basic macro-economics. Simply put, monetary policy is now too easy and the money base is expanding too fast, especially in light of the collapse in nominal growth.

As a result of loose monetary policy, divergence between the growth rate of nominal money supply and GDP (depicted below) has resulted in excess RMB liquidity and facilitated capital flight. In addition to the imbalance in growth rate, China’s nominal GDP stands at US$11 trillion while money supply (M2) is over US$21 trillion.

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A structural change in China’s macro-economics is therefore needed to stem FX reserve depletion, but this will undoubtedly pose as a hindrance to economic growth. The changes could be: (i) impose strict capital controls, (ii) tighten monetary policy, and (iii) one-off large enough devaluation of the RMB.

Firstly, stricter capital controls could be imposed, as the Bank of Japan’s Governor recently requested, and stem FX reserve depletion but will ‘throw sand into the wheels of commerce’, whereby China’s export-driven economy would find it more difficult to conduct exports.

Secondly, tighter monetary policy could reduce outflow but would dampen economic growth. A hike in short-term interest rates and selling of short-term paper would reduce the money stock. This is opposite to the current loose monetary policy which allows struggling companies to refinance their obligations, resulting in a lower incidence of default. In China, this is known as banks’ ability to “evergreen” NPLs.

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Lastly, a one-off devaluation of the RMB could cause an adjustment in the confidence. Since the RMB has strengthen 25-30% against its trade-weighted basket since mid-2011 (depicted above in Figure 8), a significant devaluation of the RMB would lower the dependency on FX reserves to defend the RMB. While a significant devaluation would help alter investor sentiment, from future depreciation to future appreciation, any successful one-off depreciation may need to be around 25% or higher, according to Barclays.