Ding Shuang: The divergence of monetary policy between China and the United States may reverse in the second half of next year

Source: China Macroeconomic Forum (CMF).

Ding Shuang is the Chief Economist of Greater China and North Asia at Standard Chartered Bank

The following views are compiled from Ding Shuang's speech at the CMF Seminar on Macroeconomic Hot Issues (Issue 78).

1. Short-term divergence between exchange rate movements and fundamental valuations

The IMF's 2023 External Sector Report assesses the external conditions and exchange rate levels of major countries in 2022, with the US dollar overvalued by 3.5%-14.6% and a median of 9%, while the RMB effective exchange rate was undervalued by 1.1%-10.4% and the median was 5.7%. According to the assessment results, the valuation of the renminbi is low and there is room for appreciation, while the valuation of the US dollar is high and has a tendency to depreciate.

However, the actual movement of the exchange rate in 2023 is contrary to fundamental valuations. At the end of October this year, the bilateral exchange rate of the renminbi against the US dollar depreciated by about 6 percent compared with the end of last year, and there has been a recent correction; as far as the nominal effective exchange rate is concerned, comparing the renminbi with a basket of currencies, the calculations of the Bank for International Settlements show that the nominal effective exchange rate of the renminbi has depreciated by about 1 percent in the first 10 months; and then introducing the inflation factor to look at the real effective exchange rate, China's recent inflation is significantly lower than that of its major trading partners, and China's CPI inflation is currently slightly less than 0 percent. The GDP deflator is likely to be negative throughout the year, with our current forecast at -0.8%, meaning that China's nominal GDP growth this year will be about 0.8% lower than real GDP growth. The U.S. is still in a state of disinflation, and China's low inflation compared to its major trading partners is a depreciation of the real exchange rate of the renminbi. The depreciation of the nominal exchange rate, combined with the depreciation due to low inflation, caused the real effective exchange rate of the renminbi to depreciate by about 5% in the first 10 months. Assuming that the equilibrium exchange rate does not change much in a year, then the undervaluation of the renminbi is more serious this year, or the overvaluation of the dollar is more serious.

2. Disturbances in capital flows

The discrepancy between the conclusions of the valuation model and the actual trend is mainly due to the impact of capital flows.

1. The reserve currency attribute of the US dollar helps the US dollar get rid of the "gravity" of high valuation

The IMF's valuation model is very focused on current account movements. The flow of capital is often a very important factor in the actual determination of the exchange rate, but it is difficult to predict through models because it contains many specific factors. The dollar is overvalued in the long run and has a tendency to depreciate, but the United States can get rid of this "gravity" for a long time, which is closely related to the dollar's status as a global reserve currency. We have observed that when the U.S. economy is booming, the U.S. economy is strong, inflation is high, interest rates are high, and corporate earnings are good, capital will naturally flow into the U.S. to make up for its current-account deficit; when the U.S. economy is in recession or a global crisis, capital flows to the U.S. for safe-haven reasons; and when the U.S. economy is tepid, the value of the U.S. dollar tends to return to its reasonable valuation.

2. China's capital outflows have exacerbated the downward pressure on the RMB

For China, while it has a long-term current account surplus and is likely to remain so, capital outflows have been large in recent years. In the first 11 months of 2023, China's trade surplus reached about $750 billion, higher than the same period last year, but the massive capital account outflows still put depreciation pressure on the yuan.

In terms of FDI, China used to be a net inflow, but recently there has been a net outflow, which needs to be explained separately for foreign direct investment (FDI) and outward direct investment (ODI). FDI showed a negative value in the third quarter of this year, that is, a net outflow, which is a relatively rare phenomenon. Usually, there is a certain difference between the data of foreign direct investment (FDI) of the Ministry of Commerce and the data of foreign direct investment (FDI) of the State Administration of Foreign Exchange, and it is often the figure of the State Administration of Foreign Exchange that is higher than that of the Ministry of Commerce, which is due to the fact that the State Administration of Foreign Exchange (SAFE) records the undistributed profits or distributed and unremitted profits of foreign investors in China as direct investment (income reinvestment, but recently the figure of the State Administration of Foreign Exchange is low). On the one hand, many foreign investors adopt the "China Plus 1" strategy, and when they want to increase production capacity, they generally choose to invest outside China, resulting in a decrease in China's new capital inflows; on the other hand, due to China's interest rate cuts, the return on funds remaining in China is low, and under the strategy of capital profit seeking and supply chain diversification, the corporate headquarters requires foreign investors to repatriate profits, including previously accumulated profits. As for ODI, Chinese companies have also begun to diversify their investments, and more companies have invested in Southeast Asia, reflecting the trend of diversification of industrial and supply chains, and this trend will continue for some time.

In terms of portfolio investment, due to the widening of interest rate differentials caused by the divergence of monetary policies between China and the United States, coupled with the widespread pessimism about the Chinese economy in the market, there were continuous net capital outflows.

In terms of other investments, the projects and drivers involved are more complex, but they can be broadly seen as the demand of enterprises and residents for overseas asset allocation, which is relatively strong. Taking Hong Kong as an example, after the opening of borders after the epidemic, many mainland residents came to Hong Kong to open accounts and buy insurance. At the same time, China's private investment is relatively weak, and the first 10 months of 2023 are still negative. All of this illustrates the lack of confidence in the economy, which has led to strong demand for overseas asset allocation.

Third, the divergence of monetary policy between China and the United States may change in the second half of next year

1. It is predicted that the United States will start cutting interest rates in the third quarter of 2024

Our forecast for U.S. economic growth in 2023 is 2.5 percent, and between this year and the first half of next year, the U.S. economy will remain above trend level, with a forecast of 1.8 percent for 2024. The U.S. economy is likely to come to a standstill in the second half of next year, though a recession is not a certainty. The main reason for the forecast of the slowdown in the U.S. economy is the lagged impact of high interest rates on the economy, especially the recent rapid decline in the U.S. inflation rate, which makes the real interest rate in the U.S. rise more obviously. High interest rates have a dampening effect on investment, and the tightening of lending conditions in the United States and the high cost of financing have also had a negative impact on consumption, with high mortgage costs and the recent 10-year high default rate on consumer credit in the United States, which should deplete excess savings for most households. The employment situation, new jobs in the United States began to decrease, and the turnover rate began to decline. Under tighter credit conditions, the unemployment rate is likely to rise from 3.9% in October to 4.9% by the end of next year, which will have an impact on wage income and, in turn, consumption.

Based on the judgment of economic slowdown and downward inflation, we predict that the first US interest rate cut next year will be in the third quarter, with only 50 basis points in 2024 and another 150 basis points in 2025, while the market has recently predicted that the Fed will cut interest rates in the second quarter, and the rate cut in the second quarter will exceed 25 basis points, which is more aggressive than us.

2. China may end interest rate cuts in the second half of next year

Looking at China's economic trend, China's economy has been "developing in waves and moving forward in twists and turns" this year. In the second quarter, China's economic recovery encountered twists and turns, the third quarter saw a more obvious rebound, into the fourth quarter, October, November data compared with September is weaker, the fourth quarter from the perspective of the third quarter of the growth rate slower, but because of the low base, is expected to increase the year-on-year growth in the fourth quarter from 4.9% in the third quarter to 5.7%, the annual GDP growth can reach 5.4%. However, the two-year average growth rate should be only 4.2%, and we judge that by the end of the year, China's real economic activity will still be two to three percentage points below trend, that is, China has a negative output gap, which is also an important reason for the downward pressure on prices.

We judge that when setting the target for next year, the Central Economic Work Conference in December may consider preventing the solidification of deflationary expectations, and then set the same growth target as this year, which is about 5%. We expect growth of 4.8% next year, slightly higher than the current market consensus.

From the perspective of external demand, the contribution of net exports to China's economic growth may not turn positive. Although the economies of the United States and Europe can avoid a recession, the growth rate may be lower than this year's growth rate, in which case it will have an impact on China's external demand. However, there are also favorable factors, one is that China's nominal effective exchange rate and real effective exchange rate have depreciated this year, which will enhance China's external competitiveness. Second, in November, China's foreign trade figures, the export of integrated circuits began to turn from negative to positive, and the numbers of South Korea and Taiwan corroborate each other, which may mean that the downward cycle of the global electronics industry may have bottomed out, if the bottom rebounds, then it is beneficial to China's foreign trade. Overall, we believe that China's economy will still be driven by domestic demand next year, and the performance of imports will still be better than that of exports, so under this judgment, the contribution of net exports to China may still be negative.

From an investment perspective, the drag of real estate on China's economy is expected to slow down next year. There are two reasons for this, one is that China's housing sales and real estate investment are expected to be negative next year, but the contraction may be significantly smaller than this year, mainly because of the recent introduction of more real estate policies, more powerful policies, especially for credit support, including "white list", "three not less than" and other policies, which may make real estate credit bottom out. Therefore, the negative growth of housing sales and real estate investment is likely to be low single digits, such as negative growth between 0% and 3%, compared with the negative growth of real estate investment of 9.3% and the negative growth of residential sales of 6.8% in the first 10 months of this year, the contraction will be reduced, and at the same time, the proportion of real estate in China's economy has declined significantly in the past two years, after two consecutive years of contraction, it is roughly estimated that the proportion of real estate investment in China's GDP has fallen by 2 percentage points, from 11.7% in 2021 It fell to 9.8% in 2023 and is likely to continue to decline next year.

In terms of manufacturing investment, a recovery in the global electronics cycle could strengthen the momentum of Chinese manufacturing investment. At the same time, we expect the PPI to turn positive next year, which is also good for the profitability and investment of the manufacturing sector.

In terms of infrastructure investment, the issuance of 1 trillion yuan of special central government bonds issued at the end of October and the increase in the deficit in 2023 are more hotly discussed, although this is considered a deficit in 2023, but in fact it will really play a role in 2024. In addition, the official budget deficit rate is likely to exceed 3% next year, which we expect to be 3.5% of GDP, and the deficit in the government fund budget is likely to reach 7.7% in the broad sense. Therefore, the government provides some support for infrastructure.

On the consumption side, employment and income conditions are likely to improve amid a modest economic recovery. At the same time, from the data of the third quarter of this year, it can also be seen that the willingness of the household sector to use savings for consumption has begun to recover. Therefore, our forecast of 4.8% economic growth is based on the judgment of net exports, investment and consumption.

In this case, China's monetary policy will maintain its supportive strength, although it is a prudent monetary policy, it will still be more inclined to a counter-cyclical and stable growth trend. It is expected that in the first half of next year, there will still be RRR cuts and interest rate cuts, and by the second half of next year, the rate cuts are expected to end.

Fourth, the impact of the evolution of monetary policy between China and the United States on the exchange rate

According to our forecast, the US interest rate will remain high until the middle of next year, while China will maintain a loose monetary policy until the middle of next year, and there will be interest rate cuts, so the monetary policy divergence between China and the United States will remain in the first half of next year. If the Fed starts cutting interest rates in the third quarter of next year, it will have an impact on Treasury yields and the dollar index, which may weaken.

1. The strengthening of the yen indirectly affects the trend of the RMB exchange rate

In the near term, the yen has appreciated in anticipation that the Bank of Japan will abandon yield curve management soon. We believe that one of the key drivers of the weakening of the dollar index next year will be the appreciation of the yen, which is forecast to be 130 against the yen by the end of next year. The appreciation of the yen will indirectly affect the RMB exchange rate.

2. It is predicted that the RMB exchange rate will return to 7 by the end of next year

Taking into account seasonal factors, it is predicted that the RMB will appreciate in the short term before the Spring Festival this year. First of all, due to the recent measures of the People's Bank of China on the management of the exchange rate, enterprises can see that the upside of the US dollar is very limited, so many profit orders may be realized before the end of the year or the Spring Festival. However, after the Spring Festival, because China's interest rate differentials are still large, and the divergence of monetary policy still exists before the middle of the year, there may be a period of weakening of the yuan, and it is still possible to rebound to the level of 7.3.

The real stage of the pressure on the renminbi is likely to be in the second half of next year. Although China's interest rates are still low in the second half of the year, if China does not cut interest rates, but the United States starts to cut interest rates, this is also a kind of differentiation from another point of view. Although the absolute value is still higher than the interest rate in the United States is higher than that of China, the pressure on capital outflows will be reduced if interest rate differentials narrow, so we predict that the RMB exchange rate will be around 7 by the end of next year.

Of course, about 7 is not a very strong number, which also shows that even after the change of monetary policy dislocation, the RMB is not too much room for appreciation in the short term, which is mainly related to some factors related to capital outflow still exist, especially the trend of supply chain diversification will not change with the change of monetary policy dislocation in the short term, in addition, the demand of domestic residents and enterprises to allocate foreign assets depends on the enthusiasm of private enterprises and foreign-funded enterprises for investment in China.

3. The flexibility of the RMB exchange rate will continue to increase

According to our observations, the flexibility of the RMB exchange rate is increasing, which seems to be one of the policy objectives, and in order to promote the internationalization of the RMB in a prudent and down-to-earth manner, the flexibility of the exchange rate needs to be increased, and the RMB needs to play the role of a "shock absorber" to absorb external shocks. At the same time, we also note that the RMB can also experience a reduction in flexibility in the short term when the market is volatile, as is the recent phenomenon. Recently, the market sentiment has been volatile, and various assets have fluctuated sharply, and the central bank has increased the management of the exchange rate, on the one hand, to prevent the exchange rate from overshooting, but also to provide an anchor for the market to temporarily reduce flexibility.