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Thursday 28 March 2024

While many emerging market currencies have posted lackluster returns this year, the Chinese renminbi has been a clear outperformer, having appreciated by 5.9% against the US dollar in 2020.

There are a few important drivers that explain the currency’s appreciation this year. First of all, China has handled the COVID-19 virus better than most other countries and, as a result, has suffered to a lesser extent economically. While most countries will post negative GDP growth figures this year, China is predicted to grow by 2.0% in 2020 and another 8.1% in 2021 (Bloomberg survey of 67 economists, November 2020).

This more positive economic backdrop has also allowed the PBoC (People’s Bank of China) to enact more conservative monetary policy than most of its peers. While, at the onset of the pandemic, the PBoC cut the reverse repo and MLF rates and also reduced the reserve requirement ratio for banks, in more recent times it has normalized policy as economic growth has rebounded. As a result, after reaching a low point of 1.8% in April, five-year Chinese government bond yields have now risen to 3.2% while US Treasury yields remain at very low levels. As the PBoC aims slowly to reign in credit growth and tighten policy further in 2021, the US-China yield differential is likely to remain elevated, continuing to support the renminbi.

The COVID-19 pandemic has also provided a boost to China’s balance of payments. China’s goods exports have risen over the course of the year as demand for Chinese medical and electronic equipment has increased. These higher exports have contributed to China’s trade surplus reaching its highest level in five years.

China’s persistent services deficit has also improved considerably this year, as many of the services China typically imports from the rest of the world (such as tourism and travel) remain unavailable. This has caused the current account balance, which has been on a structural decline, to rebound recently from its lows.

Looking at China’s financial account, while net foreign direct investments (FDIs) have been broadly stable in recent years, the gradual liberalization of China’s bond markets and recent index inclusions (a topic I addressed previously) have contributed to record portfolio flows recently. Deutsche Bank estimates that there have been $116 billion in inflows to China’s bond markets this year, almost twice those of last year. Given the recent announcement by FTSE that it will include Chinese government bonds in the WGBI indices by October 2021, these flows are likely to persist in the near term, especially considering that foreign investors still make up only 3% of China’s $15 trillion bond market.

Taking a longer term view, while financial market liberalization will be extremely gradual in China and is likely to trigger bouts of volatility—for example with the recent increase in state-owned enterprise (SOE) defaults—the potential for further portfolio inflows remains enormous. Morgan Stanley estimates that, over the next decade (2021-2030), portfolio bond and equity flows into China will amount to at least $180 billion per year. These flows should therefore almost entirely offset the recurring $200 billion on average of “errors and omissions” that leave the country each year. On the whole, China’s balance of payments position therefore remains robust and supportive of the currency.

Of course, there are also risks to the view of further renminbi appreciation. One fairly obvious obstacle is that the currency has already appreciated by almost 5% (using the CFETS basket—China’s Foreign Exchange Trade System basket of currencies) since the lows in July, a relatively sharp move by historical standards. As a result, the CFETS RMB Index is now close to 96 once again, a level that had triggered the PBoC to intervene recently by allowing more outbound flows through the Qualified Domestic Institutional Investor (QDII) scheme, cutting the risk reserve ratio for FX forwards from 20% to 0%, and phasing out the countercyclical factor in the USD/CNY daily fixing. While these adjustments can be considered as gradual steps towards further market liberalization and in line with the PBoC’s pledge to intervene less in the future, they can also be interpreted as signals that the central bank remains committed to preventing the renminbi from appreciating too quickly.

Another risk to further renminbi strengthening would be a deterioration of the inflation outlook. The African swine flu reduced pork supply significantly in 2019, leading to high levels of food inflation which peaked in January 2020. Since then, food inflation has started to come down while service and producer prices remain depressed due to the pandemic. The combination of these factors have caused China’s CPI and core CPI indices to reach a ten-year low. While the relationship between inflation and the currency historically is tenuous, an episode of persistent deflation in China would probably be a hindrance to CNY strength.

Another major unknown for the renminbi remains how the Biden administration will work with China. Biden’s US election victory makes it possible for the US and China to collaborate once more, especially in areas such as the COVID-19 pandemic and climate change. On the other, the Biden administration may be tougher on other issues, such as human rights and technology. On trade, the president-elect will also not want to appear to be too soft on China, which he considers as a competitor. A roll back of previous measures and tariffs is therefore unlikely in the short term. Finally, one can also make the argument that Trump’s unilateral approach to dealing with China was not the most efficient, and that a coalition comprising the US and its historic allies could have greater sway in reshaping global trade rules over the next decade.

In summary, while the Chinese renminbi’s strength and resilience this year is in large part backed by fundamentals, further significant appreciation may be more difficult to achieve given recent strong performance and the PBoC’s more hawkish stance. In addition, uncertainties around inflation and Biden’s stance towards China could also weigh on the renminbi. As a consequence, for investors seeking exposure to Asia, currencies like the Singapore dollar, the Malaysian ringgit, the Thai baht or the Indonesian rupiah may represent a better alternative to the renminbi. These currencies will still benefit from Asia’s strong growth recovery in 2021, while potentially being less constrained in their upside.

The COVID-19-induced slowdown of the past few months has been different from past crises for a number of reasons. One of the most significant differences has been the greater ability of emerging market central banks to provide support to their economies, as we wrote about a few weeks ago. An interesting example is that of Indonesia. Last week, Indonesia’s central bank (Bank Indonesia – “BI”) cut its main interest rate (its seven day repo rate) by 25bps, from 4.25% to 4%. This was the second consecutive 25 bps rate cut in two months, the fourth this year, and brings Indonesia’s interest rates more in line with its Asian peers. Like many other central banks, BI has had to perform a delicate balancing act between supporting the economy during the pandemic and maintaining investor confidence and a stable currency. Indeed, given 40% of total corporate and government Indonesian debt is denominated in foreign currency, ensuring a stable rupiah is critical to the country’s economic prosperity.

In order to contain the virus, the government started to impose large scale social distancing in March. Unfortunately, these measures have proven only marginally effective so far in preventing the spread of the virus, at least according to the official numbers (see chart below).

The recently imposed lockdown measures, combined with weaker global demand, have taken a significant toll on Indonesia’s economy. Real GDP growth is expected to be around zero for 2020, after averaging above 5% over the past decade. Imports are down around 14% versus last year, while unemployment and poverty rates are likely to increase substantially. As a result, the government announced a series of emergency stimulus packages aimed at directing more spending towards healthcare, social protection and businesses.

While the government has received some criticism for its ability to deploy assistance quickly in such a large and fragmented country, the initial pandemic response plan announced on 31st March was interesting for a couple of reasons. First of all, this initial plan allowed Indonesia’s budget deficit to increase beyond the statutory limit of 3%, until the year 2023. Indeed, as a precautionary measure, Indonesia’s budget deficit had been capped by law at 3% ever since the 1998 global financial crisis.  For the year 2020, the government now expects the budget deficit to be 6.3% of GDP. Second, the regulation also stated that the government could finance the new pandemic spending plan through the issuance of additional bonds and, importantly, that these bonds could be purchased directly by the central bank.

This debt burden sharing scheme was finalized and revealed by the Indonesian authorities a few days ago. It provides for IDR 900 trillion of new debt-financed emergency pandemic spending (5.6% of GDP), of which the central bank will buy up to two-thirds via private placements and market auctions. This is expected to save the government around IDR 40 trillion in interest expense in 2020. More importantly, this will significantly reduce the supply of government bonds that needs to be absorbed by the private sector this year, helping to reduce yields and supporting the currency. 

While BI has purchased Indonesian government bonds in the past, such an explicit and transparent reference to future debt monetization and collaboration between the government and the central bank is quite surprising for an emerging market. In addition, BI’s approach—aimed at reducing the interest burden for the government while maintaining higher interest rates and therefore the appeal of the debt for the private sector—is also relatively innovative.  

On the flipside, BI’s actions raise the issue of central bank independence, moral hazard, and questions around how investors will react to a plan that directly subsidizes government spending and could encourage it to spend irresponsibly. To counter this argument, the Indonesian finance ministry points to the country’s track record of fiscal discipline and highlights the temporary aspect of the scheme, in that which is clearly an extraordinary state of events.

Economic textbooks also predict that such rapid increases in money supply should be inflationary. Research from Standard Chartered Global Research, looking at the historical relationship between changes in money supply and currency movements in Indonesia, concluded that the inflation rate could potentially increase by 2.4% all else being equal. That being said, one of the lessons of the past decade has been that the relationship between money supply and inflation can sometimes be quite tenuous, especially when private demand remains subdued. BI also has the option to tighten monetary policy (for example by selling back the special pandemic bonds or increasing bank reserve requirement ratios) at some point in the future, should inflationary pressures start to build up.

How have Indonesian local currency government bonds performed in this environment? After having sold off in March, government bond yields have stabilized. On the other hand, the currency has been under pressure once again over the past month, declining by 3.5% versus the US dollar. The cost of hedging Indonesia rupiah in the forward currency markets also remains relatively elevated, a sign of cautious investor sentiment. 

At a 7% yield, Indonesian government bonds are therefore attractive from a pure carry perspective, especially when compared with other investment grade local currency bonds in the JP Morgan GBI EM index (though non-resident investors should keep in mind that they will be subject to a 20% withholding tax, which will reduce their returns).  In addition, while most of the rate cuts for this year are probably now behind us, the announcement of the debt burden sharing scheme earlier this year has led to a steepening of the yield curve. This leaves ample room for investors to benefit from a potential flattening of the yield curve should, for example, the budget deficit and government bond supply ultimately be lower than currently anticipated.  

As for the currency, given the high degree of foreign ownership of Indonesian government bonds (around 38% for local currency bonds according to Moody’s), it has always been and is likely to remain quite volatile. For the currency to appreciate materially from this point onwards, one would probably need to see a sustained improvement in global investor sentiment and a return of investor flows into EM local currency assets in general, or to Indonesia in particular. 

This in itself is conditional on the speed of the economic recovery and any material progress made in overcoming the virus. While visibility in this area remains low in the short term, the new debt burden sharing plan gives Indonesian authorities greater ability to provide support to Indonesian households and corporations that need it the most.  

Earlier this week, China’s Central Bank (the PBoC) announced a further cut to the 1 year loan prime rate, one of its key interest rates, from 4.05% to 3.85%. This further loosening of monetary policy demonstrates that, as China attempts to extricate itself from the COVID-19 crisis, the domestic and international pressures on the world’s second largest economy remain severe, and the outlook highly uncertain. Last week’s publication of Q1 GDP growth numbers, industrial production, fixed assets investments and retail sales were illustrative of this state of affairs: some investors saw in the data signs of an economy starting to turn the corner, others a confirmation that global demand remains depressed and that the attempted re-opening of the Chinese economy post lock-down will be a slow and gradual process.

To get some clarity on what the future holds, it can be useful to look at the performance of Chinese financial markets. From an equities perspective, my colleague Rob Secker gave his views on Chinese equities in a recent blog (link here).

In terms of fixed income, given the segmentation of Chinese bond markets and the huge range of assets available, naturally there have been strong divergences in returns.

Renminbi denominated government bonds (CGBs) have fared on the whole relatively well this year, supported by the PBoC’s reductions notably to the 1 year and 5 year Loan Prime Rates (LPR), the 1 year Medium term lending Facility (MLF), and the 7 day and 14 day reverse repo rates. In addition, the PBoC has also directly injected trillions of renminbi into the banking system, through its outright monetary operations and by reducing reserve requirement ratios for banks.

Despite these moves, the PBoC has been relatively measured in its approach to the COVID-19 crisis, and therefore still has space to loosen monetary policy further should the crisis get worse. This should prove supportive for Chinese government bonds in the near term, especially as CGB yields remain more elevated than for example US Treasuries (currently 5 year CNY CGB yields are 2.0% and 10 year 2.6%). That being said, despite these higher yields in relative terms, the much reduced liquidity of CGBs versus US Treasuries, and the lingering restrictions around capital flows in China, mean that global investors will probably remain reluctant to increase significantly their participation in CNY denominated Chinese government bonds in the near term.

As for the renminbi, it has been one of the standout performers this year, especially when compared to other emerging market currencies. Because of this, on a year to date basis, CGBs are one of the best performing government bonds within the JP Morgan emerging markets local currency index (when calculated in US Dollars).

As a result of this outperformance, when compared to other emerging market currencies (especially those that have fallen sharply this year), the CNY arguably looks expensive, and is likely to underperform should sentiment around global demand and the COVID-19 crisis improve materially.

Versus the US Dollar, the CNY has on the whole weakened this year, and recently broke through the 7 CNY per USD mark once again. In my opinion, this has more to do with recent USD strength than fundamental CNY weakness, and the outlook for the CNY remains relatively robust. In addition, the PBoC has often stated that it does not purposely intend to devalue the CNY to boost growth, and that it aims to keep the CNY stable over the long term. Because of this, with the CNY now trading very close to multi-year lows versus the USD, the currency’s downside versus the USD looks to some extent capped. On the other hand, should USD valuations normalize, there is likely to be some decent upside potential for the CNY versus the USD.

Turning our attention now to credit, China’s deeply segmented markets have once again led to some quite large discrepancies in performances this year. The renminbi onshore market, despite the elevated debt levels of many state owned enterprises, has remained broadly resilient throughout this crisis and even posted small but positive returns (according to the S&P China Corporate Bond Index, a very broad measure of credit in China). This positive performance can in part be attributed to the fact that many investors in CNY credit tend to be buy and hold investors, and therefore the asset class did not suffer from the same forced selling pressures and USD funding stresses that wreaked havoc in financial markets in March. Many CNY credits also benefit to some extent from an implicit state guarantee, which makes the market generally more resilient, although of course there are some exceptions.

As for USD denominated corporate bonds of Chinese companies, spreads widened on the whole throughout the risk spectrum. Within investment grade, the spread widening has been relatively measured, Chinese corporate bonds outperforming the broader EM corporate IG index by over 100 basis points in spread terms this year. Some of that outperformance is probably justified by sector and quality discrepancies between China IG bonds and the wider EM index, as well as the general historical resilience of Chinese credits. But on the whole it means that, from a purely valuation perspective, there are now more compelling buying opportunities for EM investors outside of China today. This relative richness of Chinese IG credit is also exacerbated by the lack of transparency of some Chinese corporations, as well as lower levels of liquidity.

As for Chinese USD high yield bonds, after selling off massively and spreads rising to over 1,100 basis points in March, they have now retraced some of those gains and are trading around 850 basis points on average (JP Morgan CEMBI+ indices). Most of these bonds are from highly levered real estate companies that have been directly impacted by the virus outbreak, so they are not without risks. But if one focuses on those companies with stronger balance sheets, lower liquidity requirements and access to onshore funding, there are likely to be some interesting investment opportunities, on a selective basis.

Ultimately, while the COVID-19 crisis is unprecedented and has rocked financial markets, investors can be reassured by the resilience this year of Chinese government bonds and the CNY currency. As for USD denominated Chinese credit, there may be some attractive opportunities on a case by case basis, especially in the more speculative high yield space. Of course, investing in China is not without its risks. The country remains under fire internationally for its apparent initial handling of the crisis, and it is likely that the trade tensions that emerged last year will probably come back to the fore at some point. It also remains unclear at this stage whether the virus can be contained purely through social distancing measures, mass testing and isolations. Without a proper cure or vaccine readily available there could still be a second wave of infections.

Whatever your view, as the first country to be impacted by the virus and having now been able to curb the spread (at least momentarily), it is important to continue to look to China as it pursues its course towards normalization and the re-opening of its economy.

Yesterday evening, FTSE Russell announced that China Government Bonds (CGBs) would not be added to the widely followed FTSE World Government Bond Index, but remain on the watch list for inclusion until further review. This came as a surprise for most investors: Bloomberg Barclays and JP Morgan both recently added CGBs and bank policy bonds to their index suites. In challenging times for the Chinese economy, the delay means that Chinese bond markets will miss out on further inflows of billions of dollars from foreign investors. While in equity markets, China A shares have rebounded quite strongly after last year’s dismal returns, CGBs have posted disappointing results in 2019 (see chart below).

Chinese Government bonds vs selected EM and DM government bonds – YTD performance (in USD)

Following this underperformance, CGB yields now look quite attractive when compared to global developed government bonds. While CGBs are probably riskier overall, they represent an alternative source of income for investors in an increasingly yield-deprived world. 

China government bond index vs developed government bonds

However, higher yields do not necessarily translate into higher future returns. With China’s trade dispute with the US still unresolved, the short-term outlook remains uncertain for CGBs. Should the economic situation deteriorate further, it will be interesting to see the reaction of China’s central bank, the PBOC. While many options remain on the table, there are a couple of more obvious levers that the central bank could pull.

Firstly, the PBOC could reduce the Reserve Requirement Ratio (RRR), the amount of cash which banks must hold in reserves. This would free up liquidity for banks to make new loans to corporations and consumers. While the PBOC has already cut the RRR a few times since early 2018, there is still some scope to reduce it further. Based on historical movements, these further cuts would likely lead to lower CGB yields.

China reserve requirement ratio and 5 year government bonds yields

Another way in which the PBOC could loosen monetary policy is by cutting interest rates. Having evolved considerably over time, China’s monetary policy is still in a transition phase and the country has a variety of rates it could adjust to loosen monetary policy. These include the 7-day reverse repo rate as well as the medium-term lending facility, tools the PBOC has already used in the past. The recent changes made to the Loan Prime Rate also signal that this mechanism could be employed more extensively going forward. With average rates on loans still close to 6% in China, some measured monetary loosening could certainly be warranted. Reducing these key interest rates could serve as a catalyst to lower CGB yields in the future.  

Of course, investing in CGBs does not come without risks. With 70% of all bonds held by local banks which often hold them to maturity, CGBs are less liquid than other, more mature bond markets and therefore tend to react less efficiently to changes in macro-economic, monetary and financial conditions. The difficulty in hedging positions using derivative instruments, as well as regulatory and fiscal uncertainties, present further obstacles for international investors. Finally, with a debt-to-GDP ratio in excess of 300%, China remains one of the most indebted countries in the world. Deleveraging will remain a significant challenge for the country over the long run.

Foreigners investing in CGBs will also be exposed to currency risks. While China’s government has pledged not to use the currency in retaliation to trade war escalation, in reality it has been the main adjustment valve to the ebbing and flowing of trade negotiations. Following President Trump’s recent round of tariff increases in early August, the PBOC let the currency weaken past the psychologically important point of 7 CNY per USD for the first time in over a decade. While it can be expected that the PBOC will intervene to prop up the currency should it start to devalue too quickly, a further contraction of economic activity would likely result in further CNY depreciation, especially against the world’s “safe haven” currencies. On the other hand, should a reprieve or stalemate be reached in the trade negotiations, one would expect the CNY to rally quite significantly given current valuations.

Where does this leave investors? Despite the decision from FTSE Russell and lackluster government bond performance since the beginning of the year, the financial integration of Chinese financial markets – while fraught with danger – remains well under way. Given this, and indeed the many challenges that the Chinese economy faces today, the inaction so far displayed by the PBOC could prove very valuable in the future, especially if the economic backdrop continues to deteriorate. Patience in this case could very well be a virtue.

It is widely recognized that China is globally well-integrated from a trade perspective (it accounted for 13% of total world exports in 2017 according to the WTO). Yet in comparison, its financial markets remain in relative isolation. Indeed, despite having the 2nd largest equity and 3rd largest bond markets in the world (currently around $13 trillion), foreign participation in these markets remains extremely low: China still scores below India in terms of foreign participation in its equity and bond markets according to the IMF.

The situation is changing however, and China’s domestic financial markets are slowly beginning to open. This became apparent in 2011, when the renminbi Qualified Foreign Institutional Investor Scheme (RQFII) was introduced. The program allowed qualified investors to access directly the China Interbank Bond Markets (CIBM), where previously relatively strict quotas were in place. More recently, the creation of the Bond Connect (northbound link) program in July 2017 further relaxed the restrictions for eligible foreign investors in accessing the CIBM via Hong Kong. While some operational challenges remain, these initiatives from the Chinese authorities convinced Bloomberg Barclays to include Chinese renminbi-denominated (RMB) government and policy bank securities to the Bloomberg Barclays Global Aggregate Index (including the Global Treasury and EM Local index families) in April 2018. Over time the index provider estimates that RMB bonds will be the fourth largest currency component in the index after the US dollar, the euro and the Japanese yen. This was a big win for the Chinese authorities only a year after MSCI’s decision to include China A shares to their suite of EM equity indices.

So how should RMB government debt play a role in global bond portfolios? Well, with a current yield of about 3.15% and low levels of historic volatility, 10-year Chinese government bonds (CGBs) seem fairly attractive from a purely risk and return perspective. This seems especially true in today’s yield-deprived sovereign bond world, where many central banks have pledged to keep interest rates at rock bottom levels in the near term. And though the correlation of RMB government bonds may increase over time as the Chinese market becomes more integrated, they currently offer great diversification benefits versus the rest of the Bloomberg Barclays Global Aggregate index. It must be noted though that, from a currency perspective, the renminbi does not currently benefit from the same defensive characteristics as those exhibited by the typical safe haven currencies (for example the Japanese yen, the US dollar, the Swiss franc and to some extent the Euro).

Morgan Stanley Research estimates that up to $100 billion could flow into Chinese bond markets on the back of the index inclusion alone. J.P. Morgan has also put China on “index watch” for inclusion in the GBI-EM indices. Should this materialize, in time CGBs could make up 33% of the GBI-EM Uncapped index and 10% of the GBI-EM Global Diversified index.

For investors involved in emerging market debt, A+ rated Chinese government bonds sit firmly on the defensive side of the EM sovereign debt risk spectrum (see chart below). Because of this, they may have slightly less appeal strategically for EM debt fund managers (who tend to be overweight the higher yielding EM sovereign names over the long term). On the other hand, as the Chinese authorities gradually step back from the bond and currency markets, CGBs could represent a great opportunity for fund managers to add value through active management.

In addition, the prospect of low inflation and further fiscal and monetary stimulus in the face of the current economic slowdown could also make Chinese government bonds attractive in the near term. It can also be argued that as Chinese financial assets become more mainstream in 2019, the People’s Bank of China (PBoC) will be willing to use a further portion of its $3 trillion of foreign reserves to maintain stability in the currency, as it did last year.

While China’s commitment to opening its financial markets to foreigners is sincere, it is also likely that this will take time. First of all, the authorities will move with extreme caution as more volatile capital flows can represent a systemic risk and a threat to China’s economic and financial stability. In addition to this, the issue of credit markets needs to be addressed further: foreign participation in RMB credit markets is almost non-existent (estimated at 1% according to Deutsche Bank research), because many Chinese corporations benefit from an implicit state guarantee that has kept their funding costs lower and their credit ratings higher than they would be if only market forces applied. Opening China’s credit markets means putting these firms on a level playing field with the rest of the world. This adjustment has already started to take place and led to a record amount of corporate defaults in China in 2018. Additionally, further developments in areas such as corporate governance, transparency and integrity of data will also be required.

Despite these challenges in opening its markets, there are clear benefits to China. Providing easier market access to foreigners will allow a much more efficient allocation of capital in the country. It also comes at a time when China’s current account balance has been on a steady decline and is expected to move towards a more balanced – or even slightly negative – structural position. In this respect, opening the capital account should help rebalance the Chinese economy’s external position. Whatever the outcome for China, as these events unfold it is important for global fund managers gradually to shift their attention towards the East.

In its latest semi-annual statement, the Monetary Authority of Singapore (MAS) said it would slightly tighten monetary policy by increasing the slope of appreciation of the Singapore dollar Nominal Effective Exchange Rate’s (S$ NEER) policy band. This is the second increase this year, following one in April, and it confirms the broader monetary tightening recently seen in many Asian economies, such as South Korea, Malaysia, Indonesia, India and the Philippines – they all have recently raised rates to control inflation.

It may seem rather unconventional that the MAS’ primary tool for adjusting monetary policy is direct intervention in the spot and forward currency markets rather than using interest rates. Yet, the country is not alone: Costa Rica, Laos, Lebanon, Nigeria, and Vietnam all have similar arrangements, although these countries typically manage their currency versus the US dollar, rather than against a trade-weighted basket like Singapore does. A study published in 2014 by Chow et al¹ confirmed that for small and open economies like Singapore (trade represented over 300% of GDP in 2017), exchange rate-based monetary regimes were more appropriate to deal with external shocks than an interest rates-focused approach.

Singapore’s managed floating exchange rate system has been in place since 1981 and has a relatively good track record in providing price stability, as the chart below shows.

The chart also shows the estimated slope of the S$ NEER policy band (orange line), expressed in % appreciation of the S$ vs the trade-weighted basket per year (as estimated by Citi Research). Historically, the MAS has increased this slope when inflation breached the implicit 2% inflation target (for example in October 2007 or October 2010), and reduced it when inflation was more muted (October 2008 or January 2015). With the perspective that the chart shows, we also see that, despite this year’s hikes, monetary policy still remains broadly accommodative – the S$ NEER slope is still relatively low, probably around 1%, according to Citi Research.

As for the currency itself, the S$ has been relatively stable against the trade-weighted basket over the past two years, although it has started to appreciate in recent months. This can be seen in the chart below, which shows the S$ trade weighted exchange rate as calculated by the MAS, as well as estimates for the policy band according to Goldman Sachs. The MAS’ objective to achieve a gradual appreciation of the S$ over time reflects the country’s strong fundamentals and high productivity growth, which help ensure stability of capital flows.

The use of the exchange rate as the main tool to adjust monetary policy implies that the MAS cedes control over domestic interest rates, which are now guided by market forces and investors’ expectations of currency movements. This corroborates a principle known as “The Impossible Trinity,” which states that a country cannot simultaneously have free movement of capital, a fixed foreign exchange rate and control of interest rates.

The chart below shows one measure of interest rates in Singapore, 3-month S$ SIBOR, vs 3-month USD LIBOR rates in the US. While there is a positive relationship between the two, this has diverged recently, with USD LIBOR now higher than S$ SIBOR. This is partially because investors now expect the S$ to appreciate relative to the USD over time and are therefore willing to accept a lower yield on the S$, on the basis that currency appreciation will make up for the yield differential. This is a concept known as uncovered interest rate parity.

Looking ahead, aside for the domestic headwinds caused by elevated house prices and an ageing population, the economic outlook remains relatively robust for Singapore. Growth is expected to slow marginally but remains above trend, and core inflation should edge up further and stabilise just above the 2% inflation target as slack in the labour market decreases. In addition, the central bank has accumulated huge amounts of foreign exchange reserves over time and Singapore’s government debt is one of the few in the world to be rated AAA by all three major rating agencies.

For this reason, owning S$ assets within a global bond portfolio could be quite beneficial over time. Should global growth continue on its upward trajectory, the S$ is likely to continue to gradually appreciate vs the currency basket, as intended by the MAS. On the other hand, should global trade tensions and geo-political risks take a significant turn for the worse, Singapore’s strong fundamentals and the MAS’s interventions should help limit the extent of the depreciation. For example, the $S comfortably outperformed the EUR and the GBP during the last global financial crisis.

¹ “Monetary Regime Choice in Singapore: Would a Taylor Rule Outperform Exchange-Rate Management?”

The combination of the US-North Korea summit, crucial Brexit negotiations in the UK, mounting trade tensions, and a raft of central bank activity led some commentators to forecast that this would be the biggest week of the year. In fact, the beginning of the week was rather underwhelming, and it took a dovish ECB to really move markets. See how it all unfolded on today’s episode of Bond Vigilantes TV.

After a stellar 2017, eurozone economic data releases have disappointed recently. Stefan Isaacs joined me this morning to discuss the region’s prospects, focusing on the key learnings from the latest ECB meeting, why the US Treasury sell-off has so far failed to have a material impact on European rates, and implications for credit markets.

In this week’s episode, fund manager Charles de Quinsonas joined me to discuss what the recent bout of market volatility meant for the emerging markets. Were all parts of the EM bond universe equally affected, and where do we see most value today?

Having eventually emerged from the shadow of its lost decades, Japan is currently enjoying its second-longest economic expansion since World War II, having grown for seven successive quarters. John Lothian, deputy fund manager on M&G’s Japanese equity portfolios, joined me this morning to discuss the outlook for the BoJ and what the positive macro-outlook means for Japanese asset prices.

Author: Pierre Chartres

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