In this article, we provide a recap of the newest publication by China's central bank governor, Yi Gang, to gain insights into future of Chinese monetary policy, as well as understand how these new developments will be even more conducive to foreign investment in China.
***Chinese leaders have a tradition of publishing their ideas into party-run periodicals, and these writings are usually manifested into real policies. By analyzing such publications, investors can get a glimpse of China's financial future and adjust investment strategies accordingly.***
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Quality Over Quantity, with a Focus on the Real Economy
Governor Yi states that the People's Bank of China (PBOC) will focus on the quality and development of the real economy (i.e. the production, purchase and flow of goods and services) rather than the financial economy. Previously, China adopted loose monetary policy following the global financial crisis and around 2015, which resulted in extensive credit growth that translated into a boom in construction and infrastructure projects, in addition to an asset bubble in the real estate sector. While excessive lending and soaring housing prices did boost economic growth, they are of course by no means sustainable or stable, thus the Chinese government has signalled their intention to transition from high-speed economic growth to high-quality economic growth that can be sustained in the long run. Yi writes that the PBOC will adjust its policies in accordance with the development of the domestic and global economies, but will refrain from "flooding the market" with heavy quantitative easing as has been seen in other major economies.
The graph below shows the total land lease revenues earned by local governments in China, with the year labelled on the horizontal axis and total lease revenues indicated in hundreds of millions of yuan on the vertical axis. Since land is state-owned, local governments rent them out using 70-year lease contracts. Steep rises in lease revenues are evident in 2008 and 2015 when monetary easing was implemented
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Our Insights
In light of the above, we expect the Chinese government to increase its focus on promoting advanced manufacturing and transitioning from the production of low-cost, low-value products to producing higher-quality, higher-value goods, a shift that is also in line with the emphasis on supply chain reformation the government has been trying to implement over the past few years. Investors can benefit from investing in Chinese tech companies and the advanced manufacturing industry.
Maintain a Stable Value for the Yuan
Governor Yi writes that a successful economy is one that has a stable currency, backed by both a stable inflation rate and a stable foreign exchange rate. He cites examples of currency crises in the past century that have caused high income countries to fall back to the middle income tier as a result of sharp currency devaluations. Consequently, even though the PBOC has allowed the market to play a bigger role in determining the RMB exchange rate, they also intend to maintain a policy of preventing rapid depreciation or appreciation of the yuan. Since 2008, the USD/RMB exchange rate has remained in the 6:1 to 7:1 range.
The graph above shows the evolution of the USD/CNY (i.e. RMB) exchange rate over the past ten years. As a whole, the exchange rate has remained relatively stable, however, some noteworthy facts include:
Since 2005, the RMB stopped being completely pegged to the dollar as the PBOC started factoring in market demand and supply forces in determining the exchange rate.
In 2015, a reform was launched where the RMB exchange rate would not only be based on the value of the USD, but rather on a bucket of currencies. A new rule was also implemented where the State Administration of Foreign Exchange (SAFE) would use the previous day's closing rate to determine the reference rate for the next day, where a greater room for fluctuation was allowed with a 2% fluctuation threshold.
The steep increase in 2018 coincides with the US-China trade war.
Our Insights
The Chinese policymakers will likely continue to ensure that the USD/RMB rate remains within the range observed in the past. To foreign investors, this reduces but does not eliminate currency risk.
Maintain "Normal" Monetary Policy for the Long Run
Following the onset of the global financial crisis, major economies around the world have started engaging in quantitative easing (QE). Since the start of the COVID-19 pandemic in particular, quantitative easing has been taken to the extreme where many developed countries have been printing money infinitely to cope with the damage of coronavirus on their economies. Although this "abnormal" form of monetary policy has more or less become a norm in many parts of the world, Governor Yi believes that (unlimited) QE is only effective in stimulating the economy in the short run, whereas in the long run the negative consequences can outweigh any short term benefits. Specifically, unlimited QE is predicted to result in excessive debt and asset price bubbles, thereby damaging the health of the economy while also increasing income inequality and systemic risk. Governor Yi also suggests that withdrawal from unlimited QE will be very difficult once a nation has embarked on this direction, whereas maintaining "normal" monetary policy in the long run would foster sustainable economic growth and development.
The goal of maintaining a normal policy has been previously mentioned by Governor Yi in Qiushi, a party journal for Chinese leaders to share their strategies and vision for the future, since December 2019. The Governor specifically wrote that China would maintain normal monetary policy and refrain from extensive quantitative easing that could result in a steep depreciation of the yuan. In 2020, the Fed and ECB carried out massive quantitative easing to counteract the damage caused by COVID-19, while the PBOC chose to stay with traditional monetary policy, resulting in an appreciation of the Renminbi against the US dollar.
Our Insights
While interest rates in major economies have fallen to zero or below, China's one year interest rate is still around 1.5%. Consequently, pursuing "normal" monetary policy could result in an increase in the competitiveness of yuan-denominated assets in the long run.
Greater Reliance on Market Forces + Broadening Access to the Capital Markets
Governor Yi reiterated the central government's strategy of further reforming the financial markets in order to let market forces play a more dominant role in resource allocation, foreign exchange rate determination, and the determination of interest rates. He also emphasized the government's intention to promote a more diversified financial system with multi-tiered financial organization forms in order to broaden access to the capital markets. These capital market reforms will help more companies, especially SMEs, to obtain more affordable and convenient financing.
Our Insights
The Governor's statement corresponds with recent policy changes in China. China had recently launched the registration-based IPO system in 2019 on its tech-focused STAR market (a Chinese version of NASDAQ) and subsequently on the ChiNext market (a board for startups) in Shenzhen earlier this year.
The registration-based IPO system, as opposed to the traditional regulator-based system in China, allows companies to go public without getting prior approval from a regulator, as long as they fulfill the necessary disclosure requirements. This removes significant hurdles for companies trying to obtain funding via an IPO, as Chinese regulators have stringent requirements on cash flows, profitability, and etc., while also reserving the power to determine the final IPO price.
Requiring companies that wanted to go public to have a profitable track record hurt many companies that start out bleeding cash but turn very profitable later on (with tech companies being particularly notable), so the adoption of the registration-based IPO process has attracted many high quality Chinese companies to the STAR market, including Ant Group. Moreover, the Chinese Securities Regulatory Commission allows foreign incorporated Chinese companies (e.g. Alibaba, which is actually incorporated in the Cayman Islands) and Chinese companies with a dual listing abroad to trade on STAR.
With these significant reforms in the Chinese financial markets, we expect more high quality Chinese companies to choose to be listed in China, signifying a huge shift from the current tradition where top performing Chinese companies are typically listed in the US or Hong Kong.
Opening Up the Domestic Markets to Foreign Investors
Governor Yi states his support for the central government's decision to further open up the Chinese markets to foreign investors. He quotes President Xi Jinping who stated that opening up is "better early than late, and better fast than slow". Since December 2019, China has gradually allowed foreign investors to own a controlling stake in financial services companies, including securities companies, banks, and insurance companies. The PBOC has also granted foreign companies equal rights as Chinese companies in specific sectors where foreign entry was previously quite restricted, including the credit scoring and payment processing sectors. However, Governor Yi highlights that the central government would still keep a watchful eye on the opening up of domestic markets to ensure that cross-border risks remain under control and to prevent international regulatory arbitrage.
Our Insights
With the opening up of domestic markets, China is becoming increasingly attractive to foreign investors. Indeed, Vanguard is planning to exit Hong Kong and cease its operations in Japan to move its Asia headquarters to Shanghai, with a particular focus on the Chinese market (see here). It is expected that more companies will follow suit in the future.
Our Conclusion
Governor Yi Gang's article signals positive news to those interested in investing in China. Maintaining normal monetary policy with a stable foreign exchange rate for the Renminbi boosts the attractiveness of yuan-denominated assets, while also shielding investors from exchange rate risk to some extent. The capital market reforms are predicted to attract more high-quality Chinese companies that would have otherwise sought out funding abroad, and the opening up of domestic markets will allow foreign investors to access a more diversified range of investment opportunities in China.
For information on how to invest in yuan-denonimated bonds, please see:
iShares CNYB - Gaining Exposure to Chinese Government Bonds (Individual and Institutional Investors)
For information on how to invest in Chinese equities, please see:
Glossary of All China-Related Terminology:
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