RMB Biweekly – January 31th, 2017Posted by Jiazi GuoOverviewChina’s major focus in 2018 is on high quality of growth, over speed of growth. The market expects a moderate slowdown in the growth rate from 6.8% to 6.5%.At the same time, the market expects China’s monetary policy to remain the same, with a focus on tightening. Authorities want to be in sync with other central banks while avoiding too much tightening as the economic growth slows down.The PBOC will likely push for increased CNY flexibility, paving the way for a lightly managed float.The Trump administration threatens to impose trade sanctions against China, which would be a concern for the CNY.China toned down Davos forum this year, while the U.S. took over the spotlight.The offshore Chinese Yuan (CNH) gained +7.3% against the U.S. Dollar in 2017 and the onshore CNY rose +7.0%. Dollar weakness, Chinese regulator’s guidance, as well as China’s on-target growth, have all contributed to CNY’s advance.Getting down to business The Chinese government prioritized stability in 2017, ahead of the 19th Party Congress and the 40th anniversary of major economic reforms. In light of the anniversary this year, the market expects a shift in the balance towards faster reforms and increased risk-taking. Our 5 predictions for 2018 include: (1) growth to decelerate to 6.5% from 6.8% in 2017 with focus on deleveraging and targets to reduce pollution; (2) CPI inflation to increase to 2.7%; (3) PBOC to raise monetary operation rates by a total of 20bps, following the trend by major central banks; (4) USD-CNY to reach 6.45 by end of 2018, driven by a weakening USD; (5) debt-to-GDP ratio to continue to rise: expect 277% at the end of 2018, up from 270% at the end of 2017.Top three economic risks include: (1) real estate investment stalls; (2) excessive capacity cuts lead to lower growth; and (3) escalating trade friction with the US pushes trade into deficit for China.Chinese Yuan set new record highs against USD this week, highest since 2015: USD/CNH dipped 6.3882 in the offshore market and the USD/CNY traded as low as 6.3875 in the onshore market. A major risk will come from disagreements on US-China Trade, of which even talks of could hurt the Yuan.The Trump administration will decide by the end of this month about imposing trade sanctions against China. Trump has vowed to cut the U.S. trade deficit to China. Trump attended the annual World Economic Forum in Davos and delivered a speech about “America First”. On the other hand, China downplayed the event this year.The odds that the U.S. will take action has only increased, especially with record high trade imbalance announced last week. Trade conflicts may hurt China more than the US, and will be bad news for the Yuan.Furthermore, China’s domestic policies will continue to play a role in the exchange rate. The PBOC strengthened the daily reference rate for the Dollar/Yuan to 6.4169. However it is still nearly 200 pips away from the USD/CNH level at Friday’s close. A confirmation is needed from the regulator for the Yuan to advance. Their focus is to increase the use of the Yuan and maintain stability.USD/CNH In terms of technical analysis, USD/CNH is trading at around 6.3954. For a bullish setup, a target could be 6.4426. If it stands above that level, the next focus will be 6.4785. In terms of a bearish setup, a key level to watch is 6.3557 where 2017 trend line converges with 61.8% retracement of September 2017 advance.Chinese fundamentals set the foundation for a relatively stable Yuan. The economy has avoided crashing and major financial catastrophe and is expected to achieve or beat the growth target. The PBOC had also implemented a prudent monetary policy in 2017, which was tighter than in 2016, and will continue to further tighten.Dollar’s weakness and PBOC’s guidance were the other top drivers. From January to May, the USD/CNH remained mostly in a range, despite that USD weakened over the same span of time. This caused concern about a failing exchange rate regime. Therefore, the PBOC introduced a counter-cycle factor in calculating Yuan’s daily reference rate. This is a major adjustment in Chinese exchange rate regime since de-pegging the Chinese currency against the Dollar in August 2015.After this move, the Yuan restored momentum against the Dollar in the third quarter and hit the yearly-high level of 6.4433. At the end of 2017, the USD/CNH fell to a long-term support zone.Looking ahead Economic Growth Target: A Shift from Speed to QualityAfter targeting rapid growth rates for decades, China has shifted focus towards high quality growth at the end of 2017. There are high priority issues to be addressed, such as overcapacity, industrial upgrades, which the leadership aims to focus on over just the speed of growth.With this shift , China’s economic growth in 2018 will likely continue to slow down. Investors will need more leading indicators to better evaluate how well China is resolving domestic issues. Fixed asset investment, particularly private investment in fixed assets, will be useful measures. Monetary Policy: Prudent Policy in General plus Targeted MeasuresChina’s monetary policy is expected to remain neutral and prudent this year. The PBOC is facing a dilemma between loosening policy to stimulate the economy and tightening it to curb financial risks. The PBOC prioritized risk control over growth, which is also consistent with the leadership’s shift in economic goals. Therefore, the PBOC primary focus is on ensuring financial stability this year.WIth the focus on stability, the PBOC is not expected to cut interest rates. Instead, it would use various temporary tools to meet market liquidity needs in the short-term and medium-term. These include:reverse repos, Medium-term Lending Facility (MLF), Standing Lending Facility (SLF) and Temporary Liquidity Facility (TLF). The regulators can lower the reserve ratio requirements for targeted banks or temporarily allow targeted banks to reduce the reserves. As far as timing of fundamental changes in policy, it would depend on progress in controlling financial risks.Financial Risks and Regulators’ OversightSince Q3 of 2017, the PBOC has moved away from a one-policy system focused on just monetary policy to a dual system composed of both monetary policy and macroprudential policy. This is expected to continue in 2018. Macroprudential policy aims to counter against financial cycles and ensure financial stability. A major driver is the risk of a housing bubble. In order to manage this risk, the PBOC can cooperate to place further restrictions on home loans.Another issue on the regulators’ radar is undesired capital flows such as those to cryptocurrency. Last year 3 major Bitcoin platforms closed their China operations after the PBOC declared cryptocurrency Initial Coin Offerings (ICO’s) to be illegal. Furthemore banks increased oversight on individuals using credit cards overseas, and the FX regulator SAFE strengthened its crackdown on illegal cross-border FX transactions. In parallel, China’s foreign reserves gradually increased for ten straight months. In 2018, this gauge could continue to impact regulators’ tolerance and oversight on capital flows.