China’s conversion to a stronger renminbi - with an eye to Japan
China’s latest administrative currency (FX) rule changes and additional reserve requirement increases add to the evidence that policy-makers are taking deliberate measures to avoid a 1980s Japan-style bubble as it accelerates the liberalisation of its currency and rebalancing of its economy from export-driven to domestic-demand-driven. Indeed, the recent moves likely suggest further tightening ahead by Chinese authorities, in contrast to our previous expectations, to offset the potential impact of further US quantitative easing (WE). In spite of this, we believe Chinese equities remain attractively valued. Indeed, with Chinese and US leading indicators firming, 2011 returns should be well supported by stable valuations and a solid earnings outlook.
China’s policy-makers have openly expressed concern about repeating the experience of Japan following the 1985 Plaza Accord, which led to a large-scale appreciation of the yen. In the four years following, Japanese equities rose 180%, which combined with rapid rises in real estate prices and household debt. The resulting asset bubble eventually burst, leading to Japan’s lost decade's).
China appears to be laying the groundwork to better enable it to avoid the Japanese experience, yet recognizing the need to move more rapidly to the next stages of economic and currency liberalization following the global credit crisis. Indeed, China’s initial experience with liberalization of its FX market in 2005, and the renminbi strengthening that followed, only adds to the concern over Japan-like risks for the economy. When China first shifted from a dollar peg to a managed float, a surge of foreign capital and rising debt drove up domestic asset prices, with the Shanghai Composite rising 55% in the year after floating the currency and 250% two years after. On both measures, the moves exceeded the initial stages of the bubble seen in Japanese equities following the strengthening of the Japanese yen in 1985 (see chart below). With real estate prices also rising rapidly in China as they did in Japan, China rightly feared repeating Japan’s experience. With China’s return to a managed float FX regime in June, following a brief resumption of a dollar peg during the global credit crisis, China appears to be drawing lessons from its first liberalization experience.
In this context, we can characterize the initial stages of China’s economic and FX transition, over the first half of 2010, as focusing on precautionary measures to protect the financial system, such as increased capital ratios, lending restrictions and property-related measures. More recently, China’s temporary increase in reserve requirements followed by yesterday’s announcement of regulations to manage the non-trade-related FX activity of on-shore banks and companies all suggest that China is putting into place measures that will allow it to better manage large inflows and on-shore FX speculation should they return, like in 2005-07.
Whereas we previously had believed that the Chinese tightening cycle had ended in mid-2010, with the advent of US WE and the potential for this additional liquidity to find its way into the Chinese economy, China’s tightening cycle has resumed. We view China’s moves as being aimed at an incremental contraction in money supply to offset the incremental liquidity from the US WE, rather than an aggressive attempt to tighten liquidity in China’s financial system.
With the measures implemented to date expected to have a dampening effect on domestic economic activity, we expect the next stages of policy to be focused on encouraging more active rebalancing toward domestic demand. Admittedly, it will take time before a clearer evaluation of the impact of WE on domestic asset prices and inflation and the policy response can be determined.
Indeed, this policy agenda of seeking to avert meaningful asset price inflation reinforces our view that Chinese equities won’t experience another 2005-07 -style bubble driven by a surge in price-to-earnings (PE) multiples. In spite of this expectation for relatively stable PEs, Chinese equities remain attractively valued.
Indeed, with Chinese and US leading indicators firming, 2011 returns should be well supported by a solid earnings outlook even with only modest PE expansion.
Meanwhile, policy-makers are laying the foundation for more stable and sustainable growth and FX appreciation going forward.
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