“Professor Carmen Reinhart, who pioneered early warning indicators of financial crises, has suggested that the FX reserves/M2 ratio could be more informative, as it picks up China’s incompatible goals of supporting a frail banking system and defending the currency.
A credit boom is typically followed by slowing growth and rising bad debt, and the natural policy response is to support the banking sector with lower interest rates and increased liquidity. But this response can become incompatible with defending the currency if the economic outlook by China’s residents turns more negative.
Our research found that the pace at which China’s private residents diversify into foreign assets is key in determining whether net capital outflows will remain strong. Indeed, M2 growth of nearly twice real GDP growth highlights the still-significant scope for residents to convert their domestic currency deposits into foreign currency.
Structural reforms are key to restoring domestic confidence. The challenge though is that they take time and can be painful in the short run (think ridding overcapacity and deleveraging). We expect China to allow for a more flexible exchange rate (capital controls only buys some time). Our FX strategist, Craig Chan, forecasts USD/CNY will rise to 6.80 by end-2016.”
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