Engineering stability ahead of the 20th Party Congress

Please find below our latest thoughts on China:

• China capital markets have been relatively stable recently, especially considering the challenging macro environment and the movements in global markets.
• The MSCI China A Onshore Index is down around 2% over the last three months in local currency terms without marked day-to-day volatility.
• And in contrast to the rest of the world, China government bonds have delivered positive returns yearto-date. Having started the year at a significant yield premium to US Treasuries, the China 10-year government bond yield is currently around 2.65% (US 10-year Treasury: 3.41%).
• Perhaps this should be no surprise given that policymakers typically prioritise stability ahead of the five-yearly Party Congress, which will be held on 16 October. Indeed, in recent days we have seen the focus on stability play out in a number of different ways.
• Incrementally tighter Covid control measures have been put in place in response to local Covid outbreaks. Negative Covid tests are now required for those taking long-haul public transport. And policymakers have advocated “staying put” for the recent Mid-Autumn Festival (traditionally a time for families to get together) and the upcoming Golden Week in early October (when China equity markets will be closed: Trading Hour, Trading and Settlement Calendar (hkex.com.hk)

Chart 1: China equities and Stock Connect trading calendar

Source: Hong Kong Stock Exchange, as at September 2022.

• The property sector has also continued to see a lot of focus, with more effort put into ensuring property completions for projects under construction. For example, in the capital of Henan province, which hit global news headlines when demonstrations turned violent over the freezing of bank deposits, local governors have vowed to restart all suspended property construction projects in the next month. The timing ahead of the Congress is surely no coincidence.
• And there has also been an emphasis on exchange rate stability. The renminbi has depreciated by around 3% against the US dollar since the beginning of August and is approaching the psychologically important 7 per dollar threshold. The PBoC has pushed back against the pace of depreciation by cutting the FX reserve requirement ratio.
• In practice, the currency movements are more about US dollar strength than renminbi weakness. On a trade-weighted basis, the Chinese currency is close to flat ytd, with the renminbi still quite strong against other major currencies.

• Finally this week, a comment on currencies. The renminbi has depreciated by around 7% vs. the US dollar since the beginning of August.²
• The PBOC has been taking action to slow the pace of the depreciation and limiting the extent of the volatility but has not attempted to defend a specific exchange rate level.
• The central bank sets a daily fixing for the currency, and daily trading is confined to a band of 2% above and below the fixing. For some weeks now, the PBOC has consistently set the fixing at a stronger level than implied by the previous day’s trading.
• There have been other technical measures as well, which have marginally shifted incentives to short the renminbi. For example, a 20% risk reserve ratio has been reimposed on forward contracts. In reality though, this is mainly a signalling effect.
• Indeed, the current decline is more a function of US dollar strength against all currencies than a market judgement on China. YTD the renminbi has, in fact, appreciated against sterling, the euro and the yen.³
• Nonetheless, the fall in the renminbi vs. the US dollar and the growing interest rate differential between China and the US (China government 10-year bond 2.7%, US 10-year Treasury 3.7%4) has contributed to a reversal in portfolio capital flows.
• Foreign investors have been net sellers of China onshore bonds every month since February.5 The impact on equities has been more muted – foreigners have continued to be net buyers YTD, although to a lesser extent than previously.

• Party Congresses that fall on even-numbered years (2002, 2012, 2022) generally involve more changes in personnel as they mark the end of leaders who often serve in office for two terms. The Congresses that fall on odd-numbered years are more similar to the mid-term elections held for the US Congress.
• Historically, there has been an implicit age limit that helps to determine the make-up of the most senior leadership in the Politburo Standing Committee (PSC). In a convention called “7 up, 8 down”, if you are 67 years old or below, you can be elected (or re-elected) to the committee. But if you’re 68 or above, you should retire.
• Using this standard, two of the current six PSC members (other than Xi) could retire. And 11 of the 25 seats in the Politburo would be taken by new members. However, given that Xi is already 69 and is widely expected to be re-elected as President for a third term, it is unclear if the convention still holds.
• The full reshuffling of other party and government offices takes around six months and will only be completed after the so-called “Two Sessions”, which will be held in March 2023.
• As well as the usual speculation on political changes, this year’s Congress is also being viewed as a milestone for greater policy clarity.
• It would be surprising if there is any change of broad direction. As well as a focus on per capita economic growth, other features are likely to include national security, technological self-sufficiency and long-term de-carbonisation goals.
• However, there are expectations that in a post-Congress world there are prospects for better policy coordination and more decisive and efficient implementation as personnel issues are settled.
• While there are unlikely to be imminent fundamental changes in areas such as Covid and property policy – the mantra “housing is for living in, not for speculation” seems well entrenched – it is likely that the extended period of macro weakness will lead to a more pragmatic approach, accelerating when political changes are complete by the end of Q1 2023.
• Indeed, news this week that Xi Jinping has travelled abroad for the first time since the onset of the pandemic is potentially an early signal of a gradual trend towards post-Covid reopening.