(10) The canary in the coal mine for China’s currency — FT.com

https://www.ft.com/content/657ab100-65f3-11e6-8310-ecf0bddad227

The canary in the coal mine for China's currency

China's renminbi seems largely resilient one year after its sudden devaluation. The currency has weakened by only a couple of per cent against the dollar this year as the Federal Reserve has refrained from raising interest rates.
The People's Bank of China's foreign reserves have stopped falling and the spread between China's onshore and offshore exchange rates has almost vanished.
The currency's resilience, however, is unlikely to last. In particular, the amount of offshore renminbi deposits, having peaked last year when the currency was devalued, has continued to shrink this year despite the exchange rate becoming more stable again. The diminishing size of the offshore market is the canary in the mine, warning that renewed currency turbulence is likely in future.
Holding the currency outside the mainland, however, allows investors to gain exposure to China's economy without incurring its capital controls. The persistent decline in offshore deposits — down by nearly a third to $180bn over the past year — thus shows confidence in the currency remains fragile.
First, shrinking offshore renminbi deposits reflect Chinese companies paying down dollar-denominated loans after last year's devaluation increased the risk of borrowing in foreign currencies.
Local firms are using renminbi funds held outside the mainland to cut external debts. Domestic corporates are also running down onshore deposits too. But shrinking offshore renminbi holdings — having closely tracked the decline in companies' foreign borrowing over the past 12 months — indicate how capital continues to flow out of China's economy despite the current calm in the exchange rate.
Second, contracting offshore renminbi deposits also reflect the shift in retail sentiment away from holding China's currency. The renminbi has been advertised along Asia's high streets as a long-term, higher-yielding investment for individuals and households. Last year's devaluation made it clear the currency was not a one-way upward bet. This year's declines in renminbi deposits held abroad show retail investors continue to shun the currency.

Exporters appear unwilling to convert foreign earnings into renminbi deposits outside the mainland, reflecting concern the exchange rate will depreciate again in future

Third, offshore renminbi holdings are shrinking even while China continues to run large monthly trade surpluses. Exporters appear unwilling to convert foreign earnings into renminbi deposits outside the mainland, reflecting concern the exchange rate will depreciate again in future.
Last, declining offshore deposits are also tied to foreign investors unwinding renminbi carry trades. These appear to have begun in the summer of 2014 when using data from the Bank for International Settlements.
Foreign banks' consolidated claims on their Chinese counterparts — a proxy for carry trades in China's currency — peaked at $1tn before falling steadily during the past couple of years. In contrast, renminbi deposits outside the mainland only peaked when the exchange rate was devalued last August. But this year's simultaneous declines in both foreign banks' claims on onshore banks and in the amount of renminbi held offshore show confidence is low in the currency's future prospects.
Underlying the bearish sentiment on the renminbi is the fear that capital outflows will accelerate once the Federal Open Market Committee starts to tighten monetary policy again.
It was the threat of the Fed raising interest rates for the first time in a decade that prompted the PBoC to devalue the exchange rate 12 months ago.

$4tn
Peak total of PBoC's renminbi reserves in 2014, which has fallen to $3.2tn now

The renminbi's central parity rate plunged from 6.11 to 6.40 against the dollar last August. The subsequent decision by the Fed to start increasing interest rates in December led to the PBoC fixing the onshore exchange rate at 6.56 versus the greenback at the beginning of the year. Concern the Fed would raise interest rates for a second time this summer resulted in the renminbi's central rate almost reaching 6.70 last month.
The renminbi's outsize falls over the past year — and the decline in the PBoC's reserves from a peak of $4tn in 2014 to $3.2tn now — have been spurred by just one US rate rise. The fear that a series of Fed rate hikes in future will lead to greater capital outflows underpins the ongoing contraction in offshore renminbi deposits.
Holdings of renminbi outside mainland China are unlikely to vanish altogether. China's increasing weight in the global economy, the desire of long-term investors to diversify their portfolios away from major currencies like the dollar and euro and the gradual easing of capital controls should lead to the size of offshore renminbi deposits recovering over the next few years as China's currency becomes used more freely in international payments. Over time holdings of renminbi abroad may become as familiar as petrodollars are now seen outside the US.
But the current decline in offshore renminbi deposits signals confidence has not returned one year on from its sudden devaluation. Fragile sentiment is set to keep the renminbi vulnerable to further turbulence.
Mansoor Mohi-uddin is senior strategist at Royal Bank of Scotland