Source: Pinglan Guantao, originally published in China Business News on January 8, 2024.
Author: Guan Tao, Global Chief Economist of Bank of China Securities
In the third quarter of 2023, the RMB spot exchange rate (referring to the trading price at 4:30 p.m. in the domestic interbank market, the same below) continued to be under pressure, hitting a new low in nearly 16 years in early September, and the quarterly average RMB exchange rate mid-parity and spot exchange rate fell by 2.3% and 3.1% respectively quarter-on-quarter. Combined with the official balance of payments data released by the State Administration of Foreign Exchange a few days ago, we can analyze the pressures on the RMB exchange rate in the current quarter.
From the perspective of the balance of payments, the sources of pressure on the RMB exchange rate in the third quarter
After the PBOC basically withdrew from the normal foreign exchange intervention, the balance of payments between the current account and the capital account (including net errors and omissions), as well as the differences between the underlying balance of payments (including the balance between the current account and direct investment) and short-term capital flows (including securities investment, financial derivatives trading, other investment balances, and net errors and omissions) are all positive and negative mirror relationships.
In the third quarter of 2023, China's current account surplus edged down by 3% quarter-on-quarter, and the capital account deficit surged by 108%, indicating that the decline in the RMB in the quarter was mainly due to the expansion of capital outflows. During the same period, the underlying balance of payments deficit increased by US$34.8 billion quarter-on-quarter, accounting for 64% of the quarter-on-quarter decline in reserve assets, while the net short-term capital outflow increased by US$19.6 billion, or 36%. This indicates that the adjustment of the RMB in the current quarter was affected by both fundamentals and sentiment, and the impact of the reversal of the underlying balance of payments was greater.
There are two main bodies of capital outflow: foreign investment (asset side, i.e., foreign exchange collection for the people) and foreign investment (debt side, i.e., the use of foreign capital). In the third quarter of 2023, China's (non-reserve) financial account deficit increased by $66.3 billion quarter-on-quarter. Among them, the net outflow of assets was US$54.3 billion, an increase of US$36.6 billion, accounting for 55% of the increase in the non-reserve deficit, and the net outflow of liabilities was US$46.1 billion, an increase of US$29.7 billion, contributing 44%. This shows that the pressure on the RMB exchange rate in the current quarter was due to both domestic and foreign investment, and the increase in domestic capital outflow contributed more.
It should be pointed out that in 2022, the first year of the current round of RMB exchange rate adjustment, China's financial account deficit increased by 5.97 times year-on-year, of which the net outflow of assets fell by 74%, indicating that the "collection of foreign exchange from the people" in the early stage played the role of a "moat" to hedge the reversal of foreign capital flows, and the net inflow of liabilities turned from 676.4 billion yuan in the previous year to a net outflow of 29.4 billion US dollars, once again verifying that all capital flow shocks begin with inflows. In the first half of 2023, the financial account deficit increased by 30% year-on-year, of which the net outflow from the asset side decreased by 18% and the net inflow from the liability side decreased by 85%, indicating that the decline in foreign capital inflow continued to weigh on the RMB exchange rate. In the third quarter, both the asset side and the liability side had a net outflow, and the outflow pressure showed signs of spreading from foreign capital to domestic capital, which may be an important reason why the central bank frequently spoke out and acted in the second half of the year to curb the unilateral and pro-cyclical herd effect in the foreign exchange market.
Preliminary balance of payments data released earlier showed that China's foreign direct investment (FDI) showed a net outflow for the first time in the third quarter of 2023, triggering heated discussions in the market. With the release of official data, the causes and nature of net FDI outflows can be more clearly understood. Statistics show that in the quarter, China's foreign direct investment turned from a net inflow in the previous quarter to a net outflow of US$11.8 billion (consistent with preliminary data), a net outflow of US$18.5 billion from the previous quarter. Among them, the net inflow of equity investment was US$5.1 billion, basically unchanged from the previous quarter, and the debt of affiliated enterprises turned from the net inflow of the previous quarter to a net outflow of US$16.8 billion, which was the main reason for the reversal of foreign direct investment inflow in the same period. The latter reflects the impact of the Fed's tightening, the tightening of overseas financing conditions, the sharp decline in the related debt transactions of foreign-invested enterprises, and the fluctuation of the profitability of domestic and foreign-invested enterprises (the total profits of foreign-invested industrial enterprises in the first three quarters decreased by 10.5% year-on-year, a decrease of 1 percentage point higher than that of the whole of 2022), and the decline in undistributed profits. Obviously, the net foreign direct investment caused by the reversal of the debt transactions of affiliated enterprises is negative, which should not be interpreted as a large-scale withdrawal of foreign capital.
In addition, as of the end of the third quarter of 2023, the balance of China's private net external debt was US$452 billion, down 26% quarter-on-quarter, the second lowest since data (including quarterly and annual data) were available, and the ratio to annualized nominal GDP was 2.6%, down 1 percentage point quarter-on-quarter and the lowest in history. These two figures were 1,764.2 billion US dollars and 18.2 percentage points lower than those at the end of the second quarter of 2015 (on the eve of the "8.11" exchange rate reform), indicating that the mismatch of private currencies has further improved, strengthened the resilience of China's foreign economic sector, and is the confidence to resist the impact of cross-border capital flows and RMB exchange rate fluctuations.
China's position in the global industrial and supply chain from the perspective of export share
In the past year, along with the year-on-year decline in the amount of actual utilization of foreign direct investment and even the negative foreign direct investment in the balance of payments, the negative growth of foreign trade exports has also triggered market concerns about China's industrial relocation and decoupling and disconnection. Just to make this judgment, it is necessary to compare country data with global data. The United Nations Conference on Trade and Development (UNCTAD) releases global FDI data on an annual basis with a lag of more than half a year, while the World Trade Organization (WTO) releases merchandise trade data on a quarterly basis with a lag of about three months. It may be a bit hasty to conclude that China's industrial relocation has occurred from the decline in the scale of foreign investment, but the WTO's quarterly data can be used to study and judge the changes in China's position in the global industrial and supply chains.
According to the latest data, in the first three quarters of 2023, China's foreign trade exports fell by 1.9%, 4.8% and 9.9% year-on-year respectively, and the cumulative year-on-year decline in the first three quarters was 5.7%. In each quarter, China's export market share accounted for 13.39%, 14.41% and 14.70% of the global market respectively, down 0.04, up 0.43 and down 0.38 percentage points year-on-year, respectively. Although the share of exports between quarters fluctuated greatly compared with the same period last year, China's export share in the first three quarters was 14.17%, basically the same as the same period last year, only a slight decrease of 0.01 percentage points.
During the three-year period of the new crown epidemic in 2020~2022, China took measures to stabilize market players and maintain supply capacity, and the increase in export share reflected that China enjoyed the dividends of global supply chain disruptions. With the normalization of production and business activities in various countries after the epidemic eases, and the pressure on the global supply chain gradually improves, it is not surprising that the aforementioned dividends are gradually fading. However, in the first three quarters of 2023, China's export share was only 0.24 percentage points lower than the average of the same period in 2020~2022, and still 1.32 percentage points higher than the average of the same period in 2015~2019 before the outbreak of the epidemic.
In the first three quarters of 2023, the export shares of India, Indonesia, South Korea, Singapore, and Vietnam fell by 0.02, 0.08, 0.17, 0.12, and 0.04 percentage points year-on-year, respectively. It can be seen that the decline in China's export share is not due to the flow of export orders to neighboring countries, on the contrary, the year-on-year decline in the export share of neighboring countries is slightly higher than that of China.
In the first three quarters of 2023, Mexico's export market share increased by 0.20 percentage points year-on-year, 0.22 percentage points higher than the average of the same period in 2020~2022, and 0.16 percentage points higher than the average of the same period in 2015~2019, which may reflect the impact of nearshoring trade and friendly shore outsourcing. However, the proportion of Mexico's exports in the same period increased by 0.25 percentage points, 0.46 percentage points higher than the average of the same period in 2020~2022, and 0.77 percentage points higher than the average of the same period in 2015~2019. This partly reflects the fragmentation and diversification of China's export market in the context of intensifying economic and trade frictions, which is the key to China's stable position in the global industrial and supply chain in recent years.
The EU is the big winner in terms of rising export share. In the first three quarters of 2023, the share of EU exports was 30.5%, up 1.94 percentage points from the same period last year. However, considering that after the outbreak of the Russia-Ukraine conflict in early 2022, the West's joint sanctions against Russia, the energy crisis in Europe and the heavy damage to the manufacturing industry, the EU's export share fell sharply that year, down 1.65 percentage points year-on-year in the first three quarters. Therefore, the current rebound in the EU's export market share is only a recovery from a low base. In fact, in the first three quarters of 2023, the EU export market share was 0.59 percentage points higher than the average of the same period in 2020~2022, but still 0.23 percentage points lower than the average of the same period in 2015~2019.
The situation in the United States and Britain is similar. In the first three quarters of 2023, the export shares of the two countries were 8.50% and 2.18%, up 0.28 and 0.13 percentage points respectively from the same period last year, 0.42 and 0.05 percentage points higher than the average of the same period in 2020~2022, but still 0.33 and 0.38 percentage points lower than the average of the same period in 2015~2019, respectively. It can be seen that the current recovery in the export share of the United States and the United Kingdom is also a post-epidemic recovery, rather than a substantial improvement in international competitiveness.
Foreign holdings of U.S. bonds have "decreased significantly and increased in real terms", but the "siphon effect" has weakened
In 2022, the U.S. suffered a once-in-40-year high inflation, and the Federal Reserve began an aggressive tightening cycle, raising interest rates by a total of 425 basis points and starting to shrink its balance sheet seven times in a row, and the U.S. Treasury yield and the U.S. dollar index soared. For the year, the 2-year and 10-year Treasury yields rose 368 and 236 basis points, respectively, and the annual dollar index rose 12% month-on-month. Against this backdrop, the world is suffering from a "dollar shortage".
According to the U.S. Treasury Department's International Capital Flows Report (TIC), foreign investors held $7,290.1 billion in U.S. Treasury bonds at the end of 2022, a decrease of $450.3 billion from the end of the previous year. Among them, due to the rise in U.S. bond yields, foreign investors have attracted a total of 716.6 billion U.S. dollars in net purchases of U.S. bonds, the second highest since the beginning of data (second only to 772.4 billion U.S. dollars in 2008), and due to the rise in U.S. bond yields and the decline in U.S. bond prices, there was a negative valuation effect of 1,166.9 billion U.S. dollars, the highest since 2001. In the context of the "double kill of stocks and bonds", foreign investors sold a net of 226.8 billion US dollars of US stocks in the same period, which also set a new historical record, and the previous three consecutive net purchases of US stocks by foreign investors reached 415.3 billion US dollars.
From the perspective of investors, in 2022, private foreign investors will buy a total of US$898.8 billion in US bonds, the largest in history, reflecting that private foreign investors are facing the "double kill of stocks and bonds", selling risk assets and increasing their holdings of safe assets in the face of the "double kill of stocks and bonds", and the cumulative net sales of US bonds by official foreign investors are US$182.2 billion, reflecting that it is difficult for any central bank to be independent of the Fed, and some non-US central banks sell US bonds and use foreign exchange reserves to intervene in the depreciation of the local currency exchange rate. In terms of trading varieties, foreign investors bought $754 billion in medium- and long-term U.S. bonds during the same period, the largest in history, and sold $37.4 billion in short-term U.S. Treasury bills.
In 2023, the Fed tightened further, raising interest rates by 100 basis points four times throughout the year, and pausing rate hikes three times in a row since September. Since November, U.S. Treasury yields and the U.S. dollar index have both surged higher and retreated. By the end of last year, the 2-year Treasury yield had fallen 18 basis points from the end of the previous year, while the 10-year Treasury yield had closed flat, and the annual dollar index had fallen 0.5% month-on-month. In this context, the global "dollar shortage" tends to ease overall.
As of the end of October 2023, foreign investors held $7,565 billion in U.S. bonds, an increase of $275 billion from the end of the previous year. Among them, foreign investors cumulatively bought $512.8 billion of U.S. bonds, a year-on-year decrease of 10%, and as financial markets repriced the Fed's tightening stance in October, U.S. Treasury yields soared (the 10-year U.S. Treasury yield repeatedly hit the 5% mark) and U.S. bond prices fell, resulting in a negative valuation effect of $237.8 billion, a year-on-year decrease of 75%.
From the perspective of investors, in the first ten months of 2023, private foreign investors bought US$458.4 billion of U.S. bonds, down 43% year-on-year, and official foreign investors bought US$54.4 billion of U.S. bonds, compared with US$232.7 billion in the same period last year, indicating that as the Fed's tightening pace slows down, the pressure on non-U.S. central banks to intervene in the depreciation of the local currency exchange rate has eased, and they have begun to increase their holdings of U.S. bonds. In terms of trading varieties, foreign investors bought US$427.4 billion of medium- and long-term U.S. Treasury bonds during the same period, down 35%, and accumulated net purchases of US$85.4 billion of short-term U.S. Treasury bills, compared with net sales of US$90.9 billion in the same period last year, reflecting that as the Fed's interest rate hikes are nearing the end, long-end U.S. Treasury yields have accelerated to catch up, and the 10-year and 2-year U.S. Treasury yields have inverted by 27 basis points per month (the lowest since August 2022), making short-term U.S. Treasury bonds more attractive to foreign investors.
As of the end of 2022, the balance of U.S. bonds held by Chinese investors was US$867.1 billion, down US$173.1 billion from the end of the previous year. Among them, Chinese investors sold US$12 billion of U.S. bonds, accounting for only 7% of the decline, and the negative valuation effect was US$161.2 billion, accounting for 93%. As of the end of October 2023, the balance of U.S. bonds held by Chinese investors was US$764.6 billion, down US$97.5 billion from the end of last year. Among them, Chinese investors have sold US$50.3 billion of U.S. bonds (up 4.56 times year-on-year), contributing 52%, and the negative valuation effect is US$47.2 billion, accounting for 48%. Unlike the previous year, when the balance of U.S. bonds held by Chinese investors was mainly caused by negative valuation effects, the pace at which Chinese investors reduced their holdings of U.S. bonds has accelerated since 2023.