Forex exchange analysts noticed a chain of events that serve as a feedback to the general health of the FX inflows in China. Goldman Sachs recently observed a rebound in economic activity last July which created a rebound in August. This is interpreted as constant forex exchange flows in the months to come, which would be favourable for financial conditions. But this scenario can only happen after considering several factors, as identified by Goldman Sachs forex exchange analysts:
• Inflation: If CPI inflation continues to rise (we do not expect it to; September’s CPI reading included a large, weather-induced temporary element which will impact October CPI but unlikely beyond that), the PBoC may change its behaviour of recent quarters and become more aggressive with administrative controls on different liquidity channels. Although these controls are becoming less effective than before, they still matter. Under this kind of scenario, more FX inflows would be offset and would not necessarily lead to looser overall liquidity conditions.
• Growth: If export growth continues to be as weak as in September, overall growth may weaken as well despite looser conditions. This would likely lead to a fall in the level of FX flows.
• There have been some supply shocks to heavy IP, which tends to put downward pressure on growth. These shocks are mainly aimed at controlling pollution, which is a key focus of the new leadership. In the past, local governments often did not fully comply with orders from the central government in this area, but this time may be different as the new leadership attaches more weight to this and has made it clear that pollution control and environmental protection will form part of the criteria used to select local officials for promotions.
• Other liquidity drivers: One key driver is the net fiscal position. Despite the apparent proactive policy stance in terms of government spending in certain areas, the net fiscal position as measured by the change in government balance has been tight. Should it remain as such, interbank liquidity may continue to be relatively tight even if FX continues to flow in.
Forex exchange strategists argued that there is a optimistic feedback mechanism in the Chinese economy. This could be the rise in the momentum of growth that stimulated higher FX inflows. Greater forex exchange inflows tend to stimulate looser financial conditions, that helps the growth momentum. The range of FX flows also rebounded after the bounce in growth momentum in July. Growth momentum might have weakened in September and this could weigh on FX flows
A good relationship between economic growth and industrial production and FX flows can be normal as rebound in industrial production growth could be driven by export growth which ushers in more forex exchange inflows. Some delays can bring about lead lag relationships, since forex exchange traders in China are not required by the law to convert FX into CNY immediately. Goldman Sachs believes that this resulted from changes in growth momentum that result to varying expectations about the forex exchange and interest rates, that impact investor’s interest to convert currency.
Non-Trade FX Flows
Non-trade FX flows is totally different from the ordinary meaning of “hot money”. Non-trade FX factors in foreign direct investment (FDI). By factoring in FDI, it will render a more accurate value of “hot money”. The other way around, Chinese FDI is highly correlated with variances in the forex exchange rate. This situation is possible because hot money can pretend as direct investment. Real direct investments are impacted by currency appreciation considerations. There is always a marginal difference between hot and cold investments.
Higher FX flows could lead to less stricter domestic liquidity with all things equal. Liquidity can be measured using quantitative tools such as M2 and Total Social Financing (TSF) and measurements such as interbank interest rates like the 7-day repo rate. CNY converted from FX flows directly form part of M2. It is therefore normal to expect a positive correlation between the two.
If not all else equal, the non-FX portion of M2 is negatively correlated with FX flows. The negative relationship dould happen because monetary regulators react to volatilities in FX flows to sustain the stability in broad money supply growth.
The volatilities in forex exchange market flows may also impact liquidity through the effect on funding costs. But the correlations between the FX flows and interbank FX flows is complicated. The greater forex exchange inflows there are, the less restriction on interbank liquidity and lower interest rates tend to be. A lower interest rate signify a lower rate differential, which in turn cut down more FX inflows. The relationship between these two variables is not yet clear before 2010. There has been negative correlation between the two variables since 2010.
This new established relationship in the variables show a change in the monetary policy regime as the monetary regulators in the domestic interbank market to lesser extent in the context of lower levels of FX flows. The low level of flows tends to make liquidity conditions more constricted. This is perfect for the hawkish bias of the monetary regulators. This bias is already factored in, the interbank rate has climbed during strong growth and high inflation periods. But the interest rate has been on an uptrend versus the first half of this year even though there is weaker inflation and higher growth. These changes are translated as increased influence of the People’s Bank of China on its monetary policy in line with other policymakers under the new administration.
It may also be an interpretation of the emerging dilemma facing the central bank due to constant innovations in the financial system.Tighter administrative controls that do not add up to funding costs among commercial banks have been inefficient due to launching of new financial products like trust agreements that allow commercial banks to bypass administrative controls. These only occurs when liquidity demand and activity growth in the economy are sturdy. Policies that does not allow higher funding costs for commercial banks are effective in minimising domestic credit supply. Even then, this will still expand the interest rate spread and this will induce more FX inflows, which is something that is not pleasing when the economy is already performing well.