Exchange Rates

Bottom Line: Japanese Central Bank Governor Haruhiko Kuroda raised eyebrows in Davos with his call for the Chinese government to consider controls to stem capital flight. The idea is less radical than it seems; although comprehensive liberalization is theoretically the ideal option, capital controls may be China’s best chance to end the panic roiling global markets. Capital continues to flee China, putting downward pressure on its currency, the renminbi (RMB), and creating turmoil in global markets. The government has intervened heavily in response, but has seen a significant worsening of its external accounts, despite a large and growing trade surplus. Although central bank reserves are still a hefty $3.33 trillion, this figure fell a record $108 billion in December and is now down more than $650 billion from its 2014 peak (see figure 1). Anecdotally, capital outflows accelerated in January, despite a range of informal measures aimed at deterring flight. The Institute of International Finance estimates capital outflows from China at over $670 billion in 2015. FIGURE 1. EXCHANGE RATE PRESSURE AND RESERVE DEPLETION  Sources: China Foreign Exchange Trade System (CFETS); The State Administration of Foreign Exchange (SAFE). The Chinese government would have the world believe that the outflows primarily reflect a one-time unwinding of investments by Chinese firms that in recent years borrowed abroad cheaply in foreign currency and invested at higher rates domestically. This “carry trade” was thought to be on the order of $500 billion, and its unwinding resulted in the central bank providing funds mainly in dollars, allowing firms to repay the loans. If this was the only factor at play, the downward pressure on the currency and the reserve loss would be temporary. Further, the unwinding of these positions—whether viewed as dedollarization or debt repayment—would contribute to the healing of bank and corporate balance sheets and would help the government deal with the legacy of past bad debts and overcapacity in real estate and manufacturing. In late 2015, a slowing of the outflows and reasonably solid underlying economic data seemed consistent with this story. But the renewed turbulence at the start of the year suggest more fundamental and longer-acting forces are at play. There are many reasons to believe that there is a continuing incentive for capital flight from China. The easing of monetary policy, which appears to be justified in order to stabilize growth at home, leaves domestic interest rates too low relative to international rates to offset the evident risks. This means that returns at home are insufficient compensation for risk. Slowing economic growth, an anticorruption drive, and expectations of further exchange-rate depreciation all add to the pressure. A stop-and-go policy response—poorly corordinated among Chinese government agencies and poorly communicated to the public—has undermined credibility. The rapid pace of reserve loss adds to concerns that policy is on an unsustainable path, adding to the incentive for investors to get out now while they can. In many respects, a self-fulfilling run is underway. An Overvalued Currency The above arguments suggest that the RMB may need to fall further to restore market equilibrium. This is not to say that the currency is overvalued in the conventional sense. China’s reported trade surplus is significant, and it is increasing as domestic demand softens. Further, the actual trade surplus is likely to be far higher. Substantial underinvoicing of exports and overinvoincing of imports are likely, as Chinese firms move money abroad under the guise of authorized trade. Trade through Hong Kong, particularly in services, is especially suspect. Some of the recent increase in outward investments also may reflect disguised capital flight. A better way to look at the current capital outflows is as a classic exchange-rate overshooting phenomenon, as first articulated by Rudi Dornbusch in 1977. When domestic prices are sticky, a capital shock of the sort now underway in China requires a sharp increase in interest rates to stabilize the demand for domestic assets and thus the exchange rate. Absent that, the exchange rate has to depreciate beyond its long-run value to provide an adequate real return to investors while prices and activity adjust to the new environment. Over time, the adjustment of the economy will stimulate demand and the exchange rate will rebound. But until that happens, which could take six months to a year or more, the incentive to take capital out persists. Intervention in these cases can delay the depreciation of the currency, but it does not reduce the incentive to take money out and indeed can stimulate additional speculation against the currency. The central point here is that the incentive for flight persists until the exchange rate overshoots its equilibrium value. By doing do, the subsequent expectation of appreciation creates an incentive for investors to hold again. Allowing the Overshoot Policymakers have a range of options for dealing with these pressures, but employing one above all others is a recipe for trouble—it is risky to intervene without making necessary changes to domestic macroeconomic policies. This is precisely the current situation in China. From this perspective, although the rapid loss of reserves has financed the repair of Chinese balance sheets, it does nothing to stem the incentive for capital flight to continue. Indeed, the perception that the government is willing to spend large sums of money in such a situation can exacerbate pressures for flight. One option for the government is simply to allow the exchange rate to float and the overshoot to occur. Much of the economic literature, informed by Latin America’s tortured experience with unsustainable pegged exchange rates, sees a smooth and rapid adjustment as far better for the economy resisting the depreciation. More broadly, a careful program of structural reform, adequate demand support, and cautious market liberalization—including exchange markets—clearly is preferable to the continued loss of reserves. The usual policy recommendation for a country that does not want a large depreciation of its currency is to adjust domestic policies to reduce the incentive for capital flight. In this case, that means a tightening of monetary conditions. Chinese monetary policy remains highly accommodative, as measured by credit growth and offshore risk premium. Financial institutions still face significant pressures to lend to favored sectors and the central bank has moved cautiously to crack down on shadow banking excesses. All of this makes sense for a government concerned about slowing growth, but it is the wrong strategy if the goal is to stabilize foreign exchange markets. The government understandably has ruled out these options, at least to date. Largely, that reflects domestic political constraints on how quickly the reform process can proceed. From an international perspective, a rapid depreciation of the RMB would be met by copycat measures from many trading partners and protectionist pressures globally. It would adversely effect global risk sentiment, generate a race to the bottom as other countries followed the RMB down, and provide relatively limited benefit to a Chinese economy already in surplus and committed to a domestic rebalancing and working off of manufacturing sector imbalances and excess capacity. Further, a large Chinese depreciation would spur substantial protectionist pressures, particularly in the United States where populist, anti-Chinese sentiment would find fertile ground. For all these reasons, capital controls appear to be the lesser evil for the Chinese government. Capital Controls to Buy Time A common criticism is that capital controls would be a step backward in the ongoing effort to encourage the international use of the RMB, including through its inclusion in the special drawing rights (SDR) basket of the International Monetary Fund (IMF), beginning in September 2016. Indeed the IMF has sent mixed signals on financial reform, at times urging a go-slow approach even as it made foreign-exchange-market reform a condition for accepting the RMB into the SDR. In the Fund’s defense, its SDR decision speaks to the RMB being freely useable for transactions between member countries, and does not require that the RMB be convertible on and offshore for the private sector. Further, the IMF has cautioned correctly against too much momentum toward liberalization before hard budget constraints and other preconditions for successful reform are in place. That said, the decision to include the RMB in the SDR was seen by many in China as an important step toward improved status in the international economic arena and as a catalyst for further liberalization, and controls would be a step back in that regard. From this perspective, there is a compelling case for capital controls as a temporary, stabilizing measure to relieve exchange-market pressure and allow time for the authorities to address existing imbalances. To some extent, such an effort is already underway, as the government reportedly has moved to crack down on misreporting of trade and provided informal guidance to banks to limit transfers. More formal controls and montioring are likley to be needed to constrain complex multinational companies from shifting funds abroad. This is far from the ideal policy, but may well be the constrained best option for a government trying to regain credibility and stabilize its markets. Looking Ahead: Kahn's take on the news on the horizon Europe The European Central Bank’s promise to ease policy in March has provided temporary market stability, but the expected measures may not produce a material demand boost. Still, the message from central bankers globally is that negative interest rates are working better than expected. Nigeria Nigeria is the latest oil-exporting country to seek international support; an IMF program may be unavoidable. Greece If negotiations stall between Greece and its European partners, “Grexit” is likely to return as a market concern.

Bottom Line: Summer has seemingly brought a new optimism about the Russian economy. Russia’s economic downturn is coming to an end, and markets have outperformed amidst global turbulence.  But the coming recovery is likely to be tepid, constrained by deficits and poor structural policies, and sanctions will continue to bite. Brexit-related concerns are also likely to weigh on oil prices and demand. All this suggests that Russia’s economy will have a limited capacity to respond to future shocks.           Recovery’s Green Shoots Summer has seemingly brought a new optimism about the Russian economy. Markets have soared: the ruble is the best-performing emerging market currency this year, up over 20 percent since late January against the dollar, and equities have posted double-digit gains. Russian markets have benefited from a range of macroeconomic and technical factors—a moderate pickup in oil prices, a search for yield by investors punished by low or negative interest rates in the industrial world, and a sense that the worst effects of the sanctions are in the past. Also, perhaps counterintuitively, sanctions themselves have provided support for asset prices by limiting (until recently) new issuance from Russian corporations and the government and reducing the supply of investible assets as maturing bonds are repaid. Last month’s decision by the central bank to cut interest rates for the first time since August 2015, and the hope of more cuts to come, has further boosted demand for domestic assets while reducing pressure for appreciation of the ruble. More recently, Brexit concerns had little impact on Russian markets, as the country was seen as largely insulated from global financial market contagion following its turn inward in recent years. At the same time, there are recent signs of stabilization in the economy. Growth in the first quarter was down 1.2 percent compared to last year, consistent with a bottoming out of the economy in early 2016. Activity has been boosted by improved consumer spending, as well as a shift toward domestic demand and away from imports. Capital outflows also have slowed significantly, helped by firmer oil prices, and the fiscal deficit has been contained (see figure 1). A number of market analysts are predicting that growth will turn positive in the second half of the year, producing full-year growth in 2017 on the order of 1.5 percent after three years of recession. Both the International Monetary Fund (IMF) and World Bank also have recently upgraded their forecast and complimented the government and central bank for their strong macroeconomic policy management—including a flexible exchange rate regime, banking sector capital and liquidity, sensible fiscal policies, and regulatory forbearance to keep lending going. FIGURE 1. Russia’s Federal Government Revenue and Fiscal Balance (percent of GDP, left axis) Adding to the optimism is a growing expectation that European sanctions will be eased when they are next up for renewal at the end of 2016. During the June 2016 decision by the European Council to renew the financial, energy, and defense sanctions for another six months, council members reportedly disagreed over the future course of sanctions policies and many members felt that full compliance with Minsk II, the political framework for addressing the conflict between Russia and Ukraine, was not going to be an effective test for future decisions on sanctions. These are the building blocks of an improving outlook. But I have a less sanguine view: Russia’s recovery may not be enough to bring the country out of its protracted economic crisis. Three Reasons to Worry About the Russian Economy The first reason for tempered optimism on the Russian economy is that the macroeconomic developments underpinning the recent boost to growth are running out of steam. The rebound in energy prices this year has produced a welcome influx in foreign exchange, but energy prices are still well below the price needed to balance the budget or provide stability to the balance of payments. Meanwhile, the 37 percent depreciation of the ruble against the U.S. dollar in 2015 provided a price advantage for Russia’s export sector that continued to support demand even as the ruble began to rebound this year. This lag in the response of trade to the exchange rate (called the “J-curve”) is transitory, and the benefits from this earlier depreciation are now largely exhausted at the same time as the more recent appreciation is beginning to bite. Further, the drag to global growth from Brexit is likely to weigh more heavily on oil prices and demand later this year. Thus, although the IMF sees Russia as having an exchange rate policy that is appropriate for the current setting, the policy is not sufficiently competitive to sustain a strong cyclical recovery in growth. Second, as shown in figure 1, in the past few years deficits have forced a significant running down of Russia’s international funds, a process that cannot continue indefinitely. Russia will empty its Reserve Fund, one of its two sovereign funds (set up to save oil wealth when prices were high), during 2017 and will start dipping into the National Welfare Fund. That fund holds over $70 billion, but it includes illiquid investments in the Russian state development bank Vnesheconombank and other state-favored projects. This suggests the reserves available for budgetary financing are less than they seem. Unsustainable deficits need not lead to crisis, but they do mean that in future years there will need to be some combination of fiscal tightening and external borrowing to fill fiscal and external gaps. Recent reports suggest that the Finance Ministry is expected to increase domestic borrowing significantly, assuming that international borrowing will remain constrained by sanctions. At the same time, non-sanctioned Russian companies are returning to international bond markets with a wave of new issuance (nearly $2 billion in June alone). In addition, a debate in the Duma over a tightening of capital controls in the fall will be an early test of whether the politics of deficits are changing. Third, and most important, Russia’s economic downturn reflects deep-seated structural problems that had come to the surface well before the downturn in energy prices in 2014–2015, challenges that will continue to constrain growth. Weak institutions, extensive government intervention in labor and product markets, and disincentives to invest all create an excessive reliance on exports of natural resources. In addition, the prevalence of corruption and weak rule of law will continue to deter investors and businesses from entering the market, especially non-resource sectors, hindering competiveness and innovation. The government’s anti-crisis plan in 2016 speaks to the need for reform: in addition to fiscal stimulus, it contains measures to improve the investment climate by reducing regulatory uncertainty and strengthening judicial processes. But little has been done so far in terms of concrete measures, and I am far from convinced that this program, if implemented, will address the fundamental structural challenges that are preventing the creation of a diversified, market-oriented economy—changes that are needed to sustain above-trend growth and raise real incomes in coming years. Conclusion A rebound in oil prices, coupled with sound macroeconomic policies, has moderated the economic downturn and supported domestic financial markets. A modest economic recovery may now be in train. But the fundamentals of the Russian economy remain weak; markets are distorted and too dependent on energy exports. Without a far more comprehensive reform process, tough budget cuts will be necessary over the next few years, and the recovery could prove transitory. In this context, policy uncertainty and political reality weigh heavily on the economic outlook for Russia.   Looking Ahead: Kahn's take on the news on the horizon Brexit Attention now turns to informal discussions that could set the stage for a British invocation of Article 50 (beginning the formal exit process) before the end of the year. Italian Banks The Bank of Italy’s stress test will likely reveal a large capital hole in major Italian banks, forcing a confrontation with European leaders over whether a government injection of capital will require a bail-in of these bank’s private creditors. Interest Rate Cuts The Bank of England has held back on a rate cut, for now, but the Bank of Japan and European Central Bank meet with interest rate cuts on the table amid growing concerns of a Brexit-induced slowdown.