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GLOBAL MACRO RESEARCH CHINA'S EXTERNAL BALANCES: PAST, PRESENT AND FUTUREJUNE 2020

2

THE PAST

• Current account: The current account has shifted from substantial surplus to a state of near balance today.

Several factors account for this including a shift toward a more consumption-led growth model and an

increasingly negative services balance driven by higher levels of outbound tourism.

• Foreign direct investment: China was a consistent net recipient of foreign direct investment over much of the

last 30 years. This is no longer the case. Inflows have slowed down, while outflows have increased as China seeks

to strengthen its connectivity to the world.

THE PRESENT

• A massive investment undertaking: China’s Belt and Road Initiative involves vast foreign direct investment

outflows and is expected to involve over US$1trn worth of investments across many countries. If successfully

implemented, this initiative could help re-orient a large part of the world economy toward China.

• An unremarkable balance of payments position: Today, China’s external balances appear relatively

unremarkable when compared with those for other major economies.

THE FUTURE

• Current account: We expect further downward pressure on China’s current account as imports increase relative

to exports, while outbound tourism continues to accelerate.

• Income balances: The income balance position should remain broadly unchanged.

• Portfolio flows: China will likely have a greater requirement for external financing given the ongoing deterioration

in the current account. We expect portfolio inflows to increase as capital controls are eased.

• Foreign direct investment (FDI): We expect China’s net FDI position to continue to deteriorate, in part because

of the Belt and Road Initiative, but remain broadly neutral in terms of its contribution to the capital account.

EXECUTIVE SUMMARY

POLICY AND INVESTMENT IMPLICATIONS

A more open capital account: It seems likely that China will need to further relax its capital account

as it further integrates into the global financial system.

Currency: While a deteriorating current account should put pressure on the renminbi, we believe

capital inflows from Chinese bond and equity index inclusion and a drive to internationalise the

renminbi should make currency stability more likely.

Bonds and equities: We believe both Chinese bonds and equities should benefit from greater

demand technicals as they enter global investment indices.

3

Figure 1: The components of a country's balance of payments

UNDERSTANDING THE BALANCE OF PAYMENTSTHE BALANCE OF PAYMENTS, WHICH INCLUDES BOTH THE CURRENT AND CAPITAL ACCOUNT, RECORDS A

COUNTRY'S INTERNATIONAL TRANSACTIONS WITH THE REST OF THE WORLD. RUNNING DEFICITS ARE NOT

NECESSARILY A BAD THING. MANY COUNTRIES HAVE BEEN RUNNING THEM SUSTAINABLY FOR DECADES, AND

FOR LESS DEVELOPED ECONOMIES THEY CAN HELP SUSTAIN INVESTMENT AT A SUFFICIENT PACE TO INCREASE

LONG-TERM GROWTH.

3

A RECORD OF A COUNTRY'S TRANSACTIONS WITH THE WORLD

The balance of payments is essentially a record of a country's international transactions with the rest of the world. It consists of three components – the current account, the capital account and a balancing component, the errors and omissions. The current account represents a country's net income over a period of time, while the capital and financial account records the net change of assets and liabilities during a particular year.

By definition, these three components must sum to zero, but imbalances may exist between individual components. For example, this can take the form of excessive surpluses or deficits, which can place stresses on a country's economic model. The constituents of the current and capital accounts are outlined in Figure 1.

1 Trade balance of goods

and services

2 Net foreign income

3 Unilateral transfers

1 Foreign direct investment (FDI)

2 Portfolio flows

3 Broad definition includes

reserve account

4 Short-term banking flows

1 Balancing item

Current account Capital and financial account Errors and omissions =0+ +

THE IMPORTANCE OF THE BALANCE OF PAYMENTS

If a country maintains a current account deficit, it needs to borrow externally, and this

makes it vulnerable to swings in investor sentiment. That said, current account deficits are

not necessarily a bad thing. Countries have been running them sustainably for decades.

In emerging markets, for example, a sustainable current account deficit is often desirable.

The lower stage of economic development necessitates greater capital goods imports in

order to sustain investment to increase long-term growth potential. Problems may arise

when the current account is driven by unsustainable domestic or international policies.

We provide historical examples of such problems in Figure 2.

Figure 2: Notable balance of payments crises

Crisis What happened

Emerging Markets:

Asian Financial crisis

1997-98

During the 1990s several South East Asian economies maintained fixed

exchange rates versus the US dollar while maintaining open capital

accounts (i.e. there are no restrictions on moving money in or out of the

country). At the time, these economies were experiencing both rapid

economic growth and high rates of investment that were financed by large

current account deficits.

Companies, banks and governments borrowed mainly in foreign currency,

essentially the US dollar, and often at short maturities. This left them

vulnerable both to currency depreciation, because the local currency value

of their US dollar obligations would increase, as well as to funding risk,

because refinancing their short-term obligations left them susceptible to

changes in investor sentiment.

Ultimately a run on the Thai baht in 1997 led to devaluation, and contagion

swept through the region. Other South East Asian economies also abandoned

their fixed exchange rate regimes, devalued their currencies, lost

competitiveness and were burdened with increased debt servicing costs.

Developed Markets:

Euro sovereign debt

crisis 2010-12

Preceding the current, we saw an expansion both in gross debt and the

cross-border supply of credit, with credit flowing into government finance

and real estate. Countries on the eurozone's periphery – such as Spain,

Greece and Portugal – saw their current account deficits widen. The

economic shock of the global financial crisis boosted the risk premia

required to finance these external imbalances, while individual countries

could not turn to currency devaluation without leaving the eurozone.

WHAT CAN BRING THE ACCOUNTS BACK TO BALANCE?

1Exchange rate: The exchange rate can be used to adjust the relative

competitiveness of a country's exports. By weakening a country's currency,

exports become cheaper while imports become more expensive. This can also

have the effect of making inward investment less attractive.

2Internal prices and demand: In situations where the exchange rate is fixed,

adjustments in domestic prices and demand become more relevant. Governments

have a role to play. They can run sizeable fiscal deficits or surpluses to offset excess

savings, or debt, respectively. Alternatively, market forces may lead to internal

price adjustments within a currency union.

4

5

Figure 3: China balance of payments % GDP1

%

� Current account � Capital account � Errors and omissions

-15

-10

-5

0

5

10

15

Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 Jan 18

Figure 4: China FX reserves (excluding gold)2

Trill

ion

USD

4

3

2

1

0Jan 80 Jan 85 Jan 90 Jan 95 Jan 00 Jan 05 Jan 10 Jan 15 Jan 20

1 Source: State Administration of Foreign Exchange (SAFE), January 2020. 2 Source: IMF, April 2020.

CHINA'S BALANCE OF PAYMENTS HAS UNDERGONE A MATERIAL TRANSFORMATION

China's accession to the WTO led to large surpluses

In the late 1990s China maintained a consistent, but small, current

account surplus which was offset by a small capital and capital

account deficit. This all changed in 2001, the year China acceded

to the World Trade Organization (WTO). From this point on China

started to accumulate significant current account surpluses. The

access it gained to new export markets, together with both its

competitive advantage in manufacturing and higher relative

growth rates to its trading partners, led to a significant current

account surplus which peaked at 12% of GDP (Figure 3).

A massive build-up in US Treasury holdings

The surplus that this current account generated needed to be

recycled somewhere. Normally, in the absence of capital controls,

current account surpluses get recycled abroad by the private

sector. However, because China has had capital controls in place,

the only way to prevent the surplus from generating significant

currency appreciation was for the central bank (PBoC) to intervene

in the market and effectively neutralize the surplus.

It did this by selling the renminbi and buying dollars to invest in US

Treasury securities. This trend was clearly seen in the capital

account where there was a significant build up in FX reserves

(US Treasuries) over this period. FX reserves peaked at around

US$4trn in 2013 (Figure 4).

THE PAST CHINA'S BALANCE OF PAYMENTS EVOLUTION CHINA'S BALANCE OF PAYMENTS HAS UNDERGONE A SIGNIFICANT TRANSFORMATION OVER THE LAST TWO

DECADES. A LARGE CURRENT ACCOUNT SURPLUS HAS SHRUNK CONSIDERABLY, CAPITAL OUTFLOWS HAVE

INCREASED, AND CHINA IS NO LONGER A NET RECIPIENT OF FOREIGN DIRECT INVESTMENT FLOWS.

THE SURPLUS HAS BEEN DECLINING SINCE 2008

The current account surplus has been in structural decline since 2008, reflecting two key

trends. First, China was growing faster than many of its trading partners and became

increasingly consumer oriented. This formed part of a broader economic trend of the

Chinese economy shifting towards a consumption-led growth model and away from the

export-led growth model it previously followed. Second, in terms of traded goods, following

the initial boost to trade after WTO accession, China started to face export markets in which

it was now the dominant player. With little ability to gain further market share in markets it

had a competitive advantage, China began to see its share of world exports stabilize in 2014

(Figure 5).

Figure 5: Share of world goods and services exports3

China

0

3

6

9

12

15 Germany

Japan

United States

China

Jan 20Jan 16Jan 12Jan 08Jan 04Jan 00Jan 96Jan 92Jan 88Jan 84

%

US Japan Germany

10.7510.34

3.65

7.21

In addition to a declining trade balance, the services balance also became increasingly negative

The services balance also became a larger negative over time, adding additional downward

pressure on the current account. This was largely driven by an increase in outbound

tourism. A US$5bn services surplus in 2008 became a deficit of nearly US$250bn in 2018.

With only 10% of the population estimated to have a passport, there's clearly a lot of scope

for this trend to continue.

3 Source: OECD, January 2020.

The services balance also became a larger negative over time,

adding additional downward pressure on the current account. This was largely driven by an increase in

outbound tourism.

6

INCREASED CAPITAL CONTROLS TO STEM OUTFLOWS

2014-2016: a period of strong capital outflow

China experienced a notable swing from capital inflows to outflows during 2014-2016.

There were several factors driving this. First, international corporates were adjusting their

balance sheets in order to reduce foreign exchange exposure to China. Second, Chinese

corporates and households were seeking to diversify assets offshore at a time when there

was also a renminbi internationalisation push. This facilitated capital outflows by

encouraging outbound investment. Thirdly, these outflows were likely amplified by higher

US interest rates and a stronger US dollar, which proved an attractive draw for capital when

set against what was a weaker outlook for the Chinese economy.

During this period, China ended up using close to US$1trn of its foreign reserves in a bid to

prevent the currency from weakening substantially (Figure 6). Depreciation mitigation was

important to avoid a vicious cycle of even more rapid capital outflows. This period led to

further policy measures to tighten capital controls in a bid to stem the outflow.

Figure 6: USD/CNY exchange rate4

4

6

8

10

Mar 20Mar 15Mar 10Mar 05Mar 00Mar 95Mar 90

Exch

ange

rat

e

NO LONGER A NET RECIPIENT OF FOREIGN DIRECT INVESTMENT

China has been a consistent net recipient of foreign direct investment (FDI) over the past

30 years, typically in the range of 2-4% of GDP (Figure 7). Policymakers began to accelerate

market-oriented reforms and to open markets to foreign capital in 1992. FDI further

accelerated when China joined the WTO in 2001.

As the Chinese macroeconomic environment deteriorated around 2014 FDI inflows began

to slow, while concurrently, FDI outflows picked up. This resulted in net FDI briefly turning

negative in 2016. The push from the Belt and Road Initiative – which we will look at in more

detail later – was one factor contributing to the pickup in FDI outflows, as were concerns

about the domestic growth and near-term currency outlook.

Figure 7: China FDI flows5

% G

DP

Net FDI � inflows � FDI outflows

-4

-2

0

2

4

6

8

Jan 20Jan 18Jan 16Jan 14Jan 12Jan 08 Jan 10Jan 06Jan 04Jan 00 Jan 02Jan 98

3 Source: OECD, January 2020. 4 Source: Bloomberg, April 2020. 5 Source: State Administration of Foreign exchange, January 2020.

7

8

A PROGRAMME TO CONNECT CHINA WITH MUCH OF THE WORLD

China's Belt and Road Initiative (BRI) (formerly known as One Belt,

One Road) aims to strengthen China's connectivity with the world.

It is an ambitious programme to connect China, with the rest of

Asia, Africa and Europe via land and maritime networks along six

corridors with the aim of improving regional integration,

increasing trade and stimulating economic growth. The name was

coined in 2013 by China's President Xi Jinping, who drew

inspiration from the concept of the Silk Road established during

the Han Dynasty 2,000 years ago – an ancient network of routes

that connected China to the Mediterranean via Eurasia for

centuries.

It has since morphed into a broad catchphrase to describe almost

all aspects of Chinese engagement abroad. It has been dubbed a

‘Chinese Marshall Plan’ by some market commentators. According

to the Asian Development Bank (ADB), Asia faces an infrastructure

funding gap of estimated US$26trn through 2030. The BRI goes

some way to trying to plug this material shortage.

There are five official aims of the BRI:

• Policy coordination

• Infrastructure connectivity

• Unimpeded trade

• Financial integration

• Connecting people

FORMATION AND IMPLEMENTATION

There is no one formal institutional body responsible for the BRI.

Instead, the formation and implementation of the BRI is managed

by a wide range of government agencies, bodies, and committees

from the central government level down to local government

level. There is an overseeing body which sits within the National

Development and Reform commission (NDRC) which oversees

guiding and co-ordinating work related to the initiative.

An important role in implementation is played by the State

International Development Cooperation Agency (SIDCA) which

was formed in April 2018. They are responsible for strategic

guidelines and policies on foreign aid and answer directly to the

State Council. Various other government agencies are also

involved in formulation and implementation of the BRI including

the Ministry of Commerce (MOFCOM), the Ministry of Foreign

Affairs (MOFA) and the Ministry of Culture (MoC). The majority of

provinces in China also have their own local BRI implementation

plans to some degree.

BRI FINANCING

Various funding channels have been utilized to meet the

significant financing needs of the BRI – estimated at over US$1trn.

While BRI bonds, private capital investment and public-private

partnerships all play a role, state-owned enterprises (SOEs) have,

and will continue to have, a crucial role in financing the initiative.

The Belt and Road Initiative is expected to involve over US$1trn in investments – equivalent to 7% of China's

GDP or 1.5% of global GDP

THE PRESENT BELT AND ROAD INITIATIVE THE BELT AND ROAD INITIATIVE AIMS TO STRENGTHEN CHINA'S CONNECTIVITY WITH THE WORLD. IT INVOLVES

VAST FOREIGN DIRECT INVESTMENT OUTFLOWS AND IS EXPECTED TO INVOLVE OVER US$1 TRILLION WORTH OF

INVESTMENT IN COUNTRIES ACROSS ASIA, AFRICA AND EUROPE.

SIZE AND SCOPE

The programme is expected to involve over US$1trn in

investments – equivalent to 7% of China’s GDP / 1.5% of global GDP.

There are some differing estimates of how much of this money has

been spent to date, although most centre around the US$250-

350bn mark. The investment has largely been in infrastructure

development for ports, roads, railways and airports, as well as

power plants and telecommunications networks. As of late 2019,

the BRI has reached approximately 138 countries that have a

combined GDP of US$29trn and a population of 4.6bn people.

IS IT CHINA’S MARSHALL PLAN?

The BRI has been called a Chinese Marshall Plan, a state-backed

campaign for a larger role on the global stage, a stimulus package

for a slowing economy, and a massive marketing campaign for

something that was already happening – Chinese investment

around the world. Whilst the BRI and Marshall Plan have many

similarities, particularly in their political-economic objectives, the

economic clout of the BRI is much more significant than the

Marshall Plan was for the US while the structure of the global

economy is very different today compared to after World War II.

If successfully implemented, the BRI could help re-orient a large

part of the world economy toward China. Increasing the amount

of trade, investment, and connectivity between China and

countries throughout Eurasia will also render these countries

more dependent on the Chinese economy, increasing China’s

economic leverage over them in the process. This may empower

China to more readily shape the rules and norms that govern the

economic affairs of the region.

Critics of the BRI are concerned China could use “debt-trap

diplomacy” to extract strategic concessions – such as over

territorial disputes in the South China Sea or silence on human

rights violations. For example, in 2011, China wrote off an

undisclosed debt owed by Tajikistan in exchange for 1,158 square

kilometers of disputed territory.

9

CHINA'S CURRENT ACCOUNT LOOKS UNREMARKABLE IN AN INTERNATIONAL CONTEXT

Set in a global context, China’s current account position is unremarkable. The US and the UK

have both run sustainable and gradually increasing current account deficits since the early

1980s. Germany’s current account surplus has strengthened significantly since the

formation of the eurozone in 1997, while Japan has run a structural current account surplus

of around 1% to 3% of GDP since 1980. China lies somewhere in the middle of the pack

globally, with a current account that is close to balanced. But it has undergone one of the

largest current account transformations over the last 10 years (Figure 8).

Figure 8: Selected current accounted balances6

-6-4-202468

1012 UK

Germany

Japan

US

China

Mar 20Mar 15Mar 10Mar 05Mar 00Mar 95Mar 90Mar 85Jun 80

% G

DP

China US Japan Germany UK

THE PRESENT CHINA’S EXTERNAL BALANCES: UNREMARKABLE ON INTERNATIONAL COMPARISON CHINA'S EXTERNAL BALANCES APPEAR RELATIVELY UNREMARKABLE

WHEN COMPARED WITH THOSE FOR OTHER MAJOR ECONOMIES. ITS

CURRENT ACCOUNT POSITION IS BALANCED, AND WHILE IT IS A NET

ACCUMULATOR OF FOREIGN ASSETS, ITS EARNINGS FROM NET FOREIGN

INCOME IS NEGATIVE.

6 Source: IMF, April 2020.

China's current account position is unremarkable in an international context.

However, it has undergone a significant transformation

10

6 Source: IMF, April 2020.

CHINA IS A NET ACCUMULATOR OF FOREIGN ASSETS, WHILE THE US IS A BORROWER

In recent years, China's accumulation of foreign assets has been the subject of increasing

public attention. While China has accumulated a material amount of net foreign assets since

2000, it is no more so than the likes of Germany and Japan, who both have much smaller

economies and populations (Figure 9).

The US meanwhile has shifted from being the world's largest creditor to the world's largest

debtor. Until the 1980s the US held 2% of global GDP in foreign assets, now they owe more

than US$4trn to the rest of the world. Persistent current account deficits have meant the US

has to borrow from the rest of the world to finance domestic consumption.

Figure 9: Net foreign assets7

-8-6-4-20246 UK

Germany

Japan

USA

China

201020001990198019701960

% gl

obal

GD

P

China US Japan Germany UK

YET THE US' NET INCOME POSITION IS POSITIVE WHILE CHINA'S IS NEGATIVE

Net foreign income tells a very different story however. The US actually comes out best on

this metric whereas China has the weakest position. This is a function of the asset

composition that each country has. China predominately owns low-yielding US Treasuries,

while its liabilities in the form of FDI inflows, generate larger income flows for developed

economies such as the US. The US is the reverse of this position, its liabilities being chiefly

low-yielding US Treasuries funding higher-yielding outwards FDI.

Figure 10: Net foreign income8

-0.15-0.10-0.050.000.050.100.150.200.250.300.35 UK

Germany

Japan

USA

China

201020001990198019701960

% gl

obal

GD

P

China US Japan Germany UK

7,8 Source: IMF, April 2020.

11

THE FUTURE CHINA'S EXTERNAL BALANCES TRAJECTORYIN THIS SECTION WE OUTLINE OUR EXPECTATIONS FOR THE TRAJECTORY

OF CHINA'S CURRENT ACCOUNT BALANCE, INCOME BALANCES,

PORTFOLIO FLOWS AND NET FOREIGN DIRECT INVESTMENT.

CURRENT ACCOUNT BALANCE

We expect gradual decline

Under our base case, we expect China's goods balance to remain positive but to

continue gradually declining, in part due to China's saturated export market share. With

China's growth rate continuing to outpace key trading partners, we expect imports to

increase at a faster rate than exports. On the services side, we expect the balance to

become increasingly negative due to outbound tourism.

Risks to this base case are two-fold, in our view. First, if China successfully moves up

the value chain it could regain and / or increase market export share in new

industries. Second, if global trade tensions re-escalate and there is a further relocation of

production chains outside of China, the goods trade balance may deteriorate quicker than

we expect.

INCOME BALANCES

Income balances should remain broadly neutral

We expect the primary and secondary income balances to remain broadly neutral

and inconsequential to the current account given its small relative size to the goods and

services trade balances.

There is a risk that it may move in a negative direction given that the composition of

the external income is made up largely of US Treasuries and is lower than the

Chinese interest rate structure.

PORTFOLIO FLOWS

We expect portfolio inflows to increase

Historically, portfolio flows have been a relatively insignificant part of China’s

external balances due to significant capital flow restrictions. This is in the process of

changing however, a shift that will likely only accelerate as support from the current account

ebbs away. China is likely to have a greater requirement for external financing going

forwards given the ongoing structural deterioration of the current account.

PORTFOLIO OUTFLOWS

Chinese investors have a significant home bias and an unbalanced asset allocation. If

restrictions to capital outflows are eased, a significant amount of outflow could potentially

take place. There are questions over the timing size of such outflows. This is one of the key

components for the direction of both the balance of payments and the Chinese renminbi.

12

PORTFOLIO INFLOWS

Bond and equity index inclusion to drive inflows

Index inclusion has been a key driver of inflows. Chinese government and policy bank bonds

entered the Bloomberg Barclays Global Aggregate Index in April 2019, the JPMorgan GBI-EM

indices in March 2020 and are likely to enter Citi's WGB Index in the next 12 to 18 months.

Index inclusion across these three indices would total around US$250-300bn (c.2% of GDP)

over the next 2-3 years with room to grow if China's weight was increased further over time.

On the equities side, Chinese equities account for c.12% of the global equity market

capitalization yet only account for c.0.25% of global equity funds holdings due to a

combination of exchange controls and other restrictions. The launch of the Stock Connect

programme and future inclusion in global equity indices could lead to inflows of c.US$100-

200bn per annum.

The renminbi as a reserve currency

Whether or not the renminbi can become a genuine reserve currency is probably the key

swing factor in determining the annual pace of net portfolio inflows over the next decade.

Global FX reserves, ex-China, currently stand at US$8.2trn with the renminbi representing

just 2.5% of this. This compares against China's 15% share of global GDP, 11.9% share in

global trade and its 10.9% weight in the IMF's special drawing rights (SDR) basket of reserve

currencies. It is a clear aim of policymakers to further expand the renminbi's role in the

global financial system, and it seems feasible that the renminbi's weight in global reserves

could increase towards 5-10% over the next decade. This would translate to c.US$50bn-

US$100bn in capital inflows per annum.

Among the key risks to this outlook include firstly, whether bond and equity indices

proceed with the inclusion of Chinese assets to the extent that we expect or not.

Secondly, if China fails to establish the renminbi as a genuine reserve currency, we are

unlikely to see its current weight change in global reserve portfolios. Lastly, if China relaxes

outbound capital controls sooner than expected there is a chance of renewed capital flight

as investors seek to diversify their portfolios.

NET FOREIGN DIRECT INVESTMENT

China's net FDI position to remain largely unchanged

We expect China's net FDI position to continue to deteriorate but remain broadly

neutral in terms of its contribution to the capital account. We could potentially see a small

drift negative as inward FDI slows further and China diversifies production abroad. We

expect policymakers to continue to expand market access, remove ownership limits and

further improve intellectual property rights protection for foreign entities. China will likely

maintain key competitive advantages in sectors in which it is the dominant player.

Furthermore, we expect China to continue to move up the value chain in global

manufacturing and continue to be a rising innovative power in hi-tech industries.

There is plenty of scope for outbound FDI to expand. Cumulative outward direct investment

to GDP currently stands at 12% which is significantly below the G3 average of 64%.

There are a few risks to this view. A further escalation of trade tensions between the

US and China could lead to a shift in FDI away from China to other markets in the

region. Additionally, if Chinese policymakers change tact and decide not to move

forward with plans to expand market access to foreign entities, we could see a reduction in

inbound FDI.

13

14

THE FUTURE POLICY AND INVESTMENT IMPLICATIONSEXTERNAL BALANCES FORECAST

Our base case is for China's current account to move from surplus

to deficit in the next 2-3 years. We expect the current account to

remain in negative territory in the medium term. We do not expect

this to prove difficult to finance without challenging financial

stability since:

1There is a strong external balance sheet (net foreign

assets) including a large quantity of liquid reserves

2Structural portfolio inflows on capital account to help

financing

3Low level of external debt, most of which is domestically

financed

4China has demonstrated an ability to move up the value

chain to help buffer the drag on the trade balance from

transitioning to a consumption-led growth model

POLICY IMPLICATIONS

The ‘impossible trinity’ is the idea that an economy can’t have

these three things at the same time: a fixed exchange rate, an

open capital account and independent monetary policy. In the

past China has claimed that it has successfully conquered the

impossible trinity, but in reality it has essentially staggered

between the three pillars. In 2005, the dollar peg was abandoned

in pursuit of a ‘managed float’ which has evolved several times

since. When the PBoC lost control of the managed float they took

firmer control of the exchange rate. However, the result was

informal lenders taking control of setting domestic interest rates.

The impossible trinity

Open capitalaccount

Fixedexchange

rate

Independentmonetarypolicy

In mid-2016 capital controls were tightened to help stem currency

weakness and have not been loosened much since. With China

opening its financial sector to global markets, this policy trade-off

is going to continue to get more difficult to manage. It seems likely

that the capital account will need to be relaxed further as China

integrates further into the global financial system and for the

renminbi to become a genuine reserve currency. This will

necessitate a reduction in influence on the level of the currency or

interest rates over time.

CURRENCY IMPLICATIONS

The deterioration in the current account into negative territory is

usually associated with a declining currency, but there are a few

idiosyncrasies that suggest that renminbi stability is more likely in

the short term:

• The current account deterioration is likely to be both gradual

and moderate

• Capital inflows from index inclusion should easily finance it

• As part of the drive to internationalize the currency, authorities

have a strong incentive to maintain a stable renminbi and have

the tools to deliver it

There are longer-term risks skewed to the downside. While capital

inflows are being liberalized at a reasonable pace – as highlighted

by index inclusions and greater accessibility to domestic

investment by corporates – the restrictions to capital outflows are

still notable. It is estimated that Chinese household net wealth is

roughly US$29trn and it is invested predominantly in real estate

and local financial assets. Therefore, a 1% reduction in home bias

could generate as much as US$289 of capital outflows – this is

more than double the size of the current account surplus.

Our base case is for the renminbi to remain stable during the

period of capital inflow liberalisation (next 1-2 years). Beyond that,

the outlook is more challenging as pressure will likely build on the

Chinese leadership to increase the liberalisation of capital

outflows.

BOND AND EQUITY MARKET IMPLICATIONS

We think that Chinese government bonds should benefit from the

positive technical of broader index inclusion over the next 2-3

years. Foreign ownership has significant room to increase beyond

the benchmark weight levels. This is one supportive factor in our

medium-term view to be long Chinese rates relative to other

markets. Chinese corporate bonds should eventually follow the

same route as government bonds for index inclusion and

increasing foreign ownership.

Chinese equities should also enjoy support from the technical of

index inclusion. However, this must be weighed against any

potential negative impact from a loosening of capital controls if

domestic investors choose to meaningfully diversify their equity

exposures.

Insight Investment

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New York, NY 10166

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CONTRIBUTORS

Harvey Bradley, Portfolio Manager, Fixed income Insight Investment

Derek Traynor, CFA Senior Investment Content Specialist Insight Investment

Francesca Fornasari, Head of Currency Solutions, Currency Management Group, Insight Investment

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15015-06-20

IMPORTANT DISCLOSURESThis document has been prepared by Insight North America LLC (INA), a registered investment adviser under the Investment Advisers Act of 1940 and regulated by the US Securities and Exchange Commission. INA is part of ‘Insight’ or ‘Insight Investment’, the corporate brand for certain asset management companies operated by Insight Investment Management Limited including, among others, Insight Investment Management (Global) Limited, Insight Investment International Limited and Insight Investment Management (Europe) Limited (IIMEL).

Opinions expressed herein are current opinions of Insight, and are subject to change without notice. Insight assumes no responsibility to update such information or to notify a client of any changes. Any outlooks, forecasts or portfolio weightings presented herein are as of the date appearing on this material only and are also subject to change without notice. Insight disclaims any responsibility to update such views. No forecasts can be guaranteed.

Nothing in this document is intended to constitute an offer or solid action to sell or a solid action of an offer to buy any product or service (nor shall any product or service be offered or sold to any person) in any jurisdiction in which either (a) INA is not licensed to conduct business, and/or (b) an offer, solicitation, purchase or sale would be unavailable or unlawful.

This document should not be duplicated, amended, or forwarded to a third party without consent from INA. This is a marketing document intended for institutional investors only and should not be made available to or relied upon by retail investors. This material is provided for general information only and should not be construed as investment advice or a recommendation. You should consult with your adviser to determine whether any particular investment strategy is appropriate.

Assets under management include exposures and cash, and are calculated on a gross notional basis. Regulatory assets under management without exposures shown can be provided upon request.

Past performance is not a guide to future performance, which will vary. The value of investments and any income from them will fluctuate and is not guaranteed (this may partly be due to exchange rate changes). Future returns are not guaranteed and a loss of principal may occur.

Targeted returns intend to demonstrate that the strategy is managed in such a manner as to seek to achieve the target return over a normal market cycle based on what Insight has observed in the market, generally, over the course of an investment cycle. In no circumstances should the targeted returns be regarded as a representation, warranty or prediction that the specific deal will reflect any particular performance or that it will achieve or is likely to achieve any particular result or that investors will be able to avoid losses, including total losses of their investment.

The information shown is derived from a representative account deemed to appropriately represent the management styles herein. Each investor’s portfolio is individually managed and may vary from the information shown. The mention of a specific security is not a recommendation to buy or sell such security. The specific securities identified are not representative of all the securities purchased, sold or recommended for advisory clients. It should not be assumed that an investment in the securities identified will be profitable. Actual holdings will vary for each client and there is no guarantee that a particular client’s account will hold any or all of the securities listed.

The quoted benchmarks within this document do not reflect deductions for fees, expenses or taxes. These benchmarks are unmanaged and cannot be purchased directly by investors. Benchmark performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in volatility, and regulatory and legal restrictions between the indices shown and the strategy.

Transactions in foreign securities may be executed and settled in local markets. Performance comparisons will be affected by changes in interest rates. Investment returns fluctuate due to changes in market conditions. Investment involves risk, including the possible loss of principal. No assurance can be given that the performance objectives of a given strategy will be achieved.

Insight does not provide tax or legal advice to its clients and all investors are strongly urged to consult their tax and legal advisors regarding any potential strategy or investment.

Information herein may contain, include or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals expansion and growth of our business, plans, prospects and references to future or success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as ‘anticipate’, ‘estimate’, ‘expect’, ‘project’, ‘intend’, ‘plan’, ‘believe’, and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Our actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements.

Insight and BNY Mellon Securities Corporation are subsidiaries of BNY Mellon. BNYMSC is a registered broker and FINRA member. BNY Mellon is the corporate brand of the Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. Products and services may be provided under various brand names and in various countries by subsidiaries, affiliates and joint ventures of the Bank of New York Mellon Corporation where authorized and regulated as required within each jurisdiction. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any government entity) and are not guaranteed by or obligations of the Bank of New York Mellon Corporation or any of its affiliates. The Bank of New York Mellon Corporation assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection there with. Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of BNY Mellon Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds and (iii) associated persons of BNY Mellon Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms.

Disclaimer for Non-US Clients: Prospective clients should inform themselves as to the legal requirements and tax consequences within the countries of their citizenship, residence, domicile and place of business with respect to the purchase and ongoing provision of advisory services. No regulator or government authority has reviewed this document or the merits of the products and services referenced herein.

This document is directed and intended for ‘institutional investors’ (as such term is defined in various jurisdictions). By accepting this document, you agree (a) to keep all information contained herein (the ‘Information’) confidential, (b) not use the Information for any purpose other than to evaluate a potential investment in any product described herein, and (c) not to distribute the Information to any person other than persons within your organization or to your client that has engaged you to evaluate an investment in such product.

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