China

Executive Summary Higher Prices Expected Higher Prices Expected Higher Prices Expected Global oil supply will move lower for a few months, until shipping can be re-routed and re-priced in response to sanctions against Russian oil producers and refiners.  In the wake of another outbreak of COVID-19 in China, oil demand will likely move marginally lower in the near term.  Chinese fiscal stimulus to support demand and Chinese equity markets will be bullish for oil, natgas and metals. Work-arounds by China and India to circumvent Western sanctions likely will keep the hit to Russian oil production contained to March and April.  However, longer term – 2024 and beyond – sanctions will put Russia's oil output on a downward trajectory. Saudi Arabia will launch an experiment this year to be paid in yuan for oil exports to China.  As a risk-management strategy, KSA needs USD alternatives for storing wealth and retaining access to its foreign reserves, given the success of sanctions in restricting Russia's access to its foreign reserves following its invasion of Ukraine. Our Brent forecast is higher, averaging $93/bbl for this year and in 2023. Bottom Line: We recommend buying the dip in any oil-and-gas equity sell-off.  We remain long the XOP ETF.  We also remain long the S&P GSCI and COMT ETF – long commodity-index based vehicles that benefit from higher commodity prices and increasing backwardation in these markets, particularly oil. Feature Shipping delays in the wake of sanctions – official and self-imposed – against Russian oil and gas exports will stretch out global hydrocarbon supply chains in 1H22. This will have the effect of reducing actual supply, as these vessels are re-routed, and work-arounds are found to get oil to ports accepting Russian material.1 Related Report  Commodity & Energy Strategy2022 Key Views: Past As Prelude For Commodities So far, China and India appear to be moving quickly to develop sanctions work-arounds. Both have long-term trading relationships with Russia, and, in the case of India, the capacity to revive a treaty covering rupee-invoicing of trade in commodities and arms. Estimates of the total hit to Russian oil production resulting from export sanctions imposed by the West following its invasion of Ukraine last month range as high as 5mm b/d in output losses, but we do not share that view.2 There is a strong desire for discounted oil in China and India, and to find alternatives to USD-denominated trade. This has been catalyzed by the sanctions on Russia's central bank and the shutdown of access to its foreign reserves. Payment-messaging systems competitive with the Brussels-based SWIFT network have been stood up already. These will be refined in the wake of the Ukraine war by states with a long-standing desire to diversify payment systems away from the world's reserve currency (i.e., the USD). Among these states, the Kingdom of Saudi Arabia (KSA) is reported to be exploring alternatives for diversifying away from USD-based payment systems, and foreign-reserves custodial relationships dependent on Western central-bank oversight – particularly the US Fed.3 In addition, as ties between China and GCC states have strengthened, the Kingdom might also be looking to diversify its defense partnerships, particularly given the open hostility between the Biden administration in the US and KSA's leadership. Monitoring Chinese state media coverage of this will provide a good indication of the extent of such cooperation. Assessing Highly Uncertain Supply In our base case, Russian output likely falls by ~ 1mm b/d over the March-April period because of shipping delays that force production to be throttled back at the margin due to storage constraints. In its magnitude, this is a similar assumption to the reference case considered by the Oxford Institute for Energy Studies (OIES) but is extended for two months (Table 1).4 We expect shipping delays and payment work-arounds to be sorted out in a couple of months, which, given the incentives of all involved, does not seem unreasonable. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply In our base case modeling, supply changes by core-OPEC 2.0 in 2022 are required to meet physical deficits brought about by less-than-expected volumes returned to the market by the entire coalition from August 2021 to now. This amounts to ~ 1.2mm b/d by our reckoning. For all of 2022, we assume core-OPEC 2.0 will lift supply by 1.3mm b/d, with most of this being provided to markets beginning in May 2022. In 2023, supplies from KSA, UAE and Kuwait are assumed to increase by roughly 0.2mm b/d, led by KSA (Chart 1). This is higher relative to our previous estimates, given our expectation, this core group will have to lift output to compensate not only for reduced Russian output and supply-chain delays this year and next, but falling output within the producer coalition's other non-core states. Outside OPEC 2.0, stronger WTI futures prices in spot markets and along the entire forward curve drive our estimate of US shale output (L48 ex-GoM) to 9.89mm b/d in 2022 (0.86mm b/d above 2021 levels) and 10.58mm b/d in 2023 (0.69mm above our 2022 levels). Supply-chain disruptions and cost inflation showing up in US shale producers' operations likely will dampen output increases.5 For the US, we expect 2022 average US production of 12.1mm b/d, or 900k b/d higher than 2021 output, and 12.8mm b/d in 2023, which is 700k b/d higher than 2022 levels (Chart 2). Chart 1Still Expecting Core-OPEC 2.0 Production Increases Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply Chart 2US Oil Output Slightly Higher US Oil Output Slightly Higher US Oil Output Slightly Higher   Higher Brent prices will encourage short-term production increases from North Sea producers and others. However, it is not clear whether this will incentivize the years-long projects that will be needed to offset the lack of capex in the sector over the past decade or so. One of our high-conviction views resulting from the dearth of capex in oil and gas production is increasingly tighter markets by mid-decade – likely apparent by 2024 – which will require higher prices to reverse the lack of investment in new production. In line with our House view, we are not restoring the return of up to 1.3mm b/d of Iranian production to markets, given the guidance from this source proved unreliable earlier this month when it suspended talks with the US on its nuclear deal. We also are not assuming ceasefire talks between Ukraine and Russia will end to the Ukraine war, given the unreliability of the source (Russia) in these reports. Softer Demand Near Term Over the next few months, we expect the recent upsurge in COVID-19 cases in China to reduce Asian demand, but not tank it relative to our existing assumptions.6 Even though this was expected in our balances estimates, we are reducing our 2Q22 demand estimate by an additional 250k b/d, which is split evenly between DM and EM economies. This reflects the direct short-term hit to EM demand from China's lockdowns and a stronger USD, which raises the local-currency costs of oil, as well as the knock-on effects of additional supply-chain disruptions. Global consumption for 2022 is expected to be 4.4mm b/d higher on average vs 2021 levels, coming in at 101.54mm b/d, and 1.7mm b/d higher in 2023 vs. 2022 levels. We expect the Russian sanctions work-arounds being pursued by China and India – together accounting for a bit more than 20% of global oil demand – will be effective and will put overall EM demand back on trend in 2H22, assuming China's COVID-19 outbreak is brought under control (Chart 3).   Chart 3COVID-19 Hits China Demand, But Does Not Tank EM Overall COVID-19 Hits China Demand, But Does Not Tank EM Overall COVID-19 Hits China Demand, But Does Not Tank EM Overall While markets remain highly fluid – subject to sharp changes in perceptions of fundaments and their trajectories – these supply-demand estimates continue to point to relatively a balanced market this year and next (Chart 4). That said, the supply-demand fundamentals still leave inventories extremely tight, which means they will  provide limited buffering against sudden shifts in supply, demand or both (Chart 5). This will, in our estimation, keep forward curves backwardated, which will support our long-term positions in long commodity-index exposure (i.e., the S&P GSCI and the COMT ETF).  Chart 4Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 5...And Inventories Remain Tight ...And Inventories Remain Tight ...And Inventories Remain Tight Our base-case balances estimates translate into a 2022 Brent price forecast that averages $93/bbl, and a 2023 average estimate of $93/bbl, which are lower than our previous forecasts of $94/bbl and $98/bbl, respectively. For 1Q22, we now expect prices to average $98/bbl; 2Q22 to average $98.25/bbl; 3Q22 $88.45/bbl; and 4Q22 $87.30/bbl. Risks To Our View The supply side of our modeling remains exposed to exogenous political risks, chiefly: A failure on the part of core-OPEC 2.0 to increase production to offset lower-than-expected output outside the coalition's core; Lower-than-expected US oil output, given stronger-than-expected production discipline; and A return of up to 1.3mm b/d of Iranian barrels, which we no longer are assuming in our balances. We continue to believe core-OPEC 2.0 will increase production because it is in their interest not to allow inventory depletion to accelerate and for prices to move higher faster. The local-currency cost of oil in EM economies – the growth engine for oil demand – is high and going higher. In real terms – i.e., inflation-adjusted terms – it is even higher, as the real effective USD trade-weighted FX rate exceeds that of the nominal rate (Chart 6). This can be seen in the local-currency costs of oil in the world's largest consumers (Chart 7). We expect an announcement from core-OPEC 2.0 by the end of this month regarding a production increase. Chart 6High Real USD FX Rates Increase Local Oil Costs Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply Chart 7Local-Currency Oil Costs In Large Consuming States Local-Currency Oil Costs In Large Consuming States Local-Currency Oil Costs In Large Consuming States   Of course, KSA's diversification to USD alternatives as a risk-management strategy makes it less certain it will lead an output increase in exchange for an increased US commitment to its defense. Regarding US shale output, producers remain disciplined in their capital allocation. Even though we expect higher prices across the WTI forward curve will incentivize additional production, we could be over-estimating the extent of this increase in our modeling. Lastly, as noted above, Iran and Russia are indicating their trade concerns have been addressed by the US, which presumably will presumably will be followed by the return up to 1.3mm b/d of production to export markets. However, forward guidance from these producers has not been particularly reliable, and we could be wrong here as well. This would be a bearish fundamental on the supply side, which would pressure prices lower. Investment Implications Given the breakdown in talks between the US and Iran – presumably under pressure from Russia for guarantees the US would not sanction its trade with Iran – our Brent price forecast remains above $90/bbl (Chart 8). We expect the near-term price increase will dissipate as the sanctions work-arounds – particularly by China and India – re-route oil flows. Core OPEC 2.0 producers – KSA, the UAE and Kuwait – have sufficient surplus capacity to increase production to allow refiners to re-build inventories. This big question for markets now is will they bring it to market in the near term? KSA's interest in exploring yuan-linked oil trade with China adds an element of uncertainty to whether production will be increased. Perhaps that is a goal of this exercise: The US is being shown there are alternatives available to large oil exporters re terms of trade and providers of defense services. Chart 8Higher Prices Expected Higher Prices Expected Higher Prices Expected There is sufficient spare capacity available at present to address the current physical deficits in global markets. Our analysis indicates markets are balanced but still tight, as can be seen in current and expected inventory levels. We remain long the XOP ETF and the S&P GSCI and COMT ETF. The latter ETFs provide long commodity-index based exposure that benefits from higher commodity prices and increasing backwardation in commodity markets generally, particularly oil.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Commodities Round-Up Precious Metals: Bullish Markets expected the Federal Reserve's rate hike of 25 basis points in the March and was not disappointed. Further rate hikes this year will occur against the backdrop of high geopolitical uncertainty and inflation, both of which are bullish for gold. The Russia-Ukraine crisis has added a new layer of complexity, and the Fed will need to proceed with caution to curb inflation but not over-tighten the economy.       Footnotes 1     Please see All at sea: Russian-linked oil tanker seeks a port, published by straitstimes.com on March 10, 2022 for examples of shipping delays. 2     Please see Could Russia Look to China to Export More Oil and Natural Gas? published by naturalgasintell.com on March 9, and India says it’s in talks with Russia about increasing oil imports., published on March 15, for additional reporting. See also Besides China, Putin Has Another Potential De-dollarization Partner in Asia published by cfr.org, which discusses India-Russia trade agreements between 1953-92 with the signing of the 1953 Indo-Soviet Trade Agreement. 3    Please see Saudi considering China’s yuan for oil purchases published by al-monitor.com on March 16. 4    Please see the OIES Oil Monthly published on March 14. 5    Oil producers in a ‘dire situation’ and unable to ramp up output, says Oxy CEO published on March 8 by cnbc.com. 6    A resurgence of COVID-19 in China was not unexpected. It was one of our key views going into 2022. Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. In that report, we noted, "… China still is operating under a zero-tolerance COVID-19 policy, and has relied on less efficacious vaccines that appear to offer no protection against the omicron variant of the coronavirus. This also is a risk for EM economies that rely on these vaccines. However, the roll-out of mRNA vaccines globally via joint ventures will be gathering steam in 2H22, which is bullish for commodity demand." We continue to expect Chinese authorities to deploy mRNA vaccines or antivirals to combat this outbreak.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. In particular, I will share our view on the announced economic growth target and stimulus measures for this year, as well as our takes on the recent developments in China’s onshore and offshore equity markets. The webcasts will be held on Wednesday, March 23 at 9:00 AM HKT (Mandarin) and Wednesday, March 23 at 9:00 AM EDT (English). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, March 30. Best regards, Jing Sima China Strategist   Executive Summary Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Chinese policymakers set an ambitious goal for this year’s economic expansion. While the growth target is above market consensus and a positive surprise, the path will be full of obstacles. Policy restrictions will be the biggest hurdle. While the authorities will continue to ease some industry policies, it is unlikely that all regulations will be rolled back at once. Therefore, it is questionable whether the announced growth-supporting measures will be enough to offset the housing slump and a slow recovery in consumption. We remain cautious on Chinese stocks. In the near term, equities will face headwinds from risk-off sentiment among global investors and a prolonged downturn in domestic demand. Policymakers will eventually allow more aggressive easing in the next 6 to 12 months. We will look for signs of more reflationary efforts and a better price entry point to upgrade Chinese stocks. We are closing our tactical trade of Long MSCI Hong Kong Index/Short MSCI ACW, due to spillover effects from Chinese offshore tech stock selloff on the Hong Kong equity market. ASSET INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG MSCI HONG KONG INDEX / SHORT MSCI ALL COUNTRY WORLD 1/19/2022 -0.08 Closed Bottom Line: Chinese policymakers are aiming for above-expectation economic growth this year. However, we recommend that investors lie low given the substantial challenges that China faces in expanding its economy. Feature Beijing set the 2022 economic growth target during last week’s National People’s Congress (NPC) at “around 5.5%”, which exceeds the market consensus. The topline growth target is encouraging. However, the announced stimulus measures are less than meets the eye. Fiscal support will increase, but not massively. Monetary policy may ease further. However, the easing efforts since July last year have failed to boost sentiment among private-sector corporates and households. Importantly, policy restrictions in the past several years, such as reducing local governments’ shadow bank borrowing and property developers’ leverage, and stringent counter-COVID measures, are having a lasting effect on the economy. As such, China’s domestic demand will likely remain sluggish until more aggressive policy easing is introduced. Meanwhile, Chinese stock prices in absolute terms have been falling due to global equity market selloffs and concerns about China’s domestic economy, although Chinese onshore stocks have fared better than their offshore peers. We expect that China will eventually allow more substantive easing to shore up growth and meet the target. Meanwhile, investors should remain cautious. We recommend that global shareholders with exposure to Chinese onshore stocks maintain a neutral position in their portfolios for now. We continue to look for signs of more reflationary efforts and the right opportunity to upgrade Chinese onshore stocks, especially if prices decline further in the near term.  We maintain our underweight stance on Chinese offshore stocks, in both absolute terms and relative to global equities. De-listing from the US stock exchange is a real risk for some of the big-name Chinese tech companies. We will provide more insights on this topic in the coming weeks. In the meantime, we are closing our tactical trade: Long MSCI Hong Kong Index/Short MSCI All Country World with a minor 0.08% loss. While the recent steep falls in the MSCI Hong Kong Index prices may provide some buying opportunities in the next 6 to 12 months, near-term downside risks are substantial due to geopolitical tensions as well as a new round of lockdowns in the mainland. An Ambitious Growth Target … The 5.5% growth goal set for 2022 is the lowest in more than three decades, but it is above the consensus forecast of close to 5% and the IMF’s projection of 4.8% (Chart 1). The target also marks a significant departure from the past couple of years and reinforces our view that the authorities are determined to ensure a stable domestic economy amid rising geopolitical turmoil (Table 1). Chart 1China Set An Above-Expectation Growth Target For 2022 China Set An Above-Expectation Growth Target For 2022 China Set An Above-Expectation Growth Target For 2022 Table 12022 Economic And Policy Targets Aiming High, Lying Low Aiming High, Lying Low The stimulus measures unveiled at last week’s NPC imply that Beijing will mainly use fiscal levers to support the economy. Some key takeaways from the published Government Work Report include: Chart 2A Significant Jump In Available SPBs In 2022 Aiming High, Lying Low Aiming High, Lying Low A bigger fiscal push. The fiscal budget is set at 2.8% of GDP this year, or 3.37 trillion yuan, and is a modest decrease from the 3.2% deficit in 2021. The quota for local government special purpose bonds (SPBs) remains unchanged at RMB3.65 trillion yuan. However, local governments will be allowed to carry over SPB proceeds from last year, which will add about RMB1.1 trillion yuan to fund this year’s spending. This translates to about RMB4.7 trillion yuan in SPB in 2022, an 80% jump from the actual usage of 2.57 trillion yuan in 2021 (Chart 2). Furthermore, tax and fee cuts will total RMB2.5 trillion yuan, more than double the 2021 amount. Small and medium enterprises will receive value-added tax credits and refunds. Tax cuts will favor the service sectors most affected by the pandemic, along with manufacturing, and science and technology research. The fiscal budget also includes a record-high transfer from the central to local governments. Adding central government fund transfers and off-budgetary fiscal expenditures, we estimate that the augmented fiscal deficit this year will be around 7.8% of GDP, implying a fiscal thrust of more than 2% of GDP. The estimated thrust will be a reversal from the negative impulse of 2.1% of GDP in 2021 (Chart 3).   Further easing in monetary policy. The government reiterated that money supply and total social financing (TSF) growth should be consistent with nominal GDP growth. We expect another cut next month in the reserve requirement ratio and/or the policy rate. We also maintain our view that the credit impulse – measured by the 12-month change in adjusted TSF as a percentage of GDP – will climb to 29% of GDP (assuming an 8% nominal GDP for 2022), 2 percentage points higher than the 27% of GDP in 2021 (Chart 4). Chart 3Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP ​​Chart 4China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Chart 5"Green Investment" Will Get A Big Boost This Year Aiming High, Lying Low Aiming High, Lying Low A more relaxed carbon reduction policy. The government did not announce an annual numeric target related to de-carbonization or energy consumption intensity reduction. Nonetheless, a more relaxed policy setting will allow flexibility, especially in the first half of the year when infrastructure projects will be accelerated. In the second half, however, there is still a risk that de-carbonization efforts will step up to align the country’s carbon and energy intensity reduction with the 14th Five-Year Plan target. Still, the negative impact from de-carbonization seen last year will be much smaller this year, while green energy development will make an increased contribution to this year’s growth (Chart 5). Bottom Line: China set an ambitious economic growth target of 5.5% for the year, relying on fiscal stimulus to shore up topline economic growth. … But A Challenging Path Ahead Achieving growth of “around 5.5%” will not be easy. As noted in previous reports, the regulations put in place in a wide range of industries since 2017 significantly constrain growth in both credit creation and the economy. Furthermore, aggressive regulatory crackdowns on the property sector and internet-related industries last year, coupled with rising domestic COVID cases and a new round of lockdowns, will likely have enduring ramifications on private-sector sentiment and weaken the effectiveness of policy easing. The following risks are notable: Constraints on infrastructure investment. We expect infrastructure investment to pick up from last year’s meager 0.5% growth. Even so, a larger fiscal impulse for 2022 would not necessarily lead to an outsized increase in infrastructure spending by local governments. In 2019, the fiscal deficit widened to 5% of GDP from 3.5% in 2018 and the quota for local government SPBs increased by 60% from a year earlier. However, infrastructure investment only grew by 3.3% in 2019, 1.5 percentage points higher than that in 2018 (Chart 6). The key factor is that the rebound in shadow banking activities, which highly correlate with infrastructure spending by local governments, was subdued in 2019. The stock of shadow banking continues to shrink in February, indicating that local governments remain extremely cautious in expanding their off-balance sheet leverage (Chart 6, bottom panel). Chart 6Shadow Bank Lending Continues To Shrink In February Shadow Bank Lending Continues To Shrink In February Shadow Bank Lending Continues To Shrink In February Chart 7Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand For Housing Remains In The Doldrums Demand for housing is still in the doldrums. February’s credit data paints a bleak picture of demand for housing, which is also reflected in recent hard data on home sales (Chart 7). It is questionable whether policymakers will allow a significant re-leverage, i.e. a 2016/17-style widespread easing in the property sector to stimulate demand for housing. So far, the government has stated that the housing policy should be city specific. Some cities have already lowered mortgage rates and down payment thresholds. Pledged supplementary lending, a tool that the government utilized to monetize massively excess inventories in the market in 2015/16, has also ticked up (Chart 8). Nevertheless, we do not expect the authorities to allow a sharp upturn in home prices or leverage by households and/or property developers (Chart 9). The government reiterated its stance at last week’s NPC that “housing is for living in and not for speculation.” Chart 8PSL Injections Ticked Up This Year PSL Injections Ticked Up This Year PSL Injections Ticked Up This Year Chart 9Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Chart 10Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Aggregate Demand For Housing Will Dwindle Along With Shrinking Labor Force Furthermore, demands for housing and property-sector investment in China are set to structurally shift lower due to the country’s slumping birthrate and shrinking working-age population (Chart 10). China’s total population will start to shrink within the next five years and the United Nations estimates that China’s marriageable population will be less than 350 million by 2030 – a drop of nearly 100 million people from 2010. Slowing urbanization rates are also a constraint for housing demand. China’s urban population growth is on a sharp downtrend; only 12 million people moved to cities last year, less than half the number who migrated in 2016. Weak consumption. The NPC reported that the government will provide support in rural areas for the consumption of new-energy vehicles (NEVs) and home appliances. There also was a mention of services for elder care and tax credits for having babies. However, there was no indication of a fiscal transfer to low-income households or a cash payout/consumption voucher to boost the marginal propensity to spend.   Chart 11Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Sharply Rising New Cases In China And Its Zero-COVID Policy Will Constraint Domestic Consumption Ultimately, it will be difficult for Chinese policymakers to bolster consumption without relaxing COVID containment measures (Chart 11). The government has made it clear that relaxing COVID policy will not be possible in the near term, given the ongoing outbreaks in China. Therefore, any improvement in household consumption, which accounts for about 40% of China’s GDP, will remain modest.  Bottom Line: China’s economic progress this year will hinge on whether a rebound in infrastructure investment can offset the negative effects from slumping demand for real estate and weak consumption. Investment Implications China will eventually ease policies more aggressively to ensure a stable domestic economic, financial and political environment against highly uncertain global and domestic backdrops. More easing and stimulus could be forthcoming by mid-2022, especially when the mainland's COVID situation is rapidly worsening and front-loaded fiscal supports will start to lose momentum. Meanwhile, Chinese stocks face substantial downside risks derived from the turmoil in global equity markets and a downturn in domestic profit growth. As witnessed in China’s onshore and offshore risk assets in the past two weeks, a slightly more positive signal from the NPC was not enough to offset the jitters from heightened geopolitical tensions and rising domestic COVID cases (Chart 12A and 12B). Chart 12AChinese Onshore Stocks Are Not Immune To Geopolitical Risks... Chinese Onshore Stocks Are Not Immune To Geopolitical Risks... Chinese Onshore Stocks Are Not Immune To Geopolitical Risks... ​​​​ Chart 12B...But Have Fared Better Than Their Offshore Peers ...But Have Fared Better Than Their Offshore Peers ...But Have Fared Better Than Their Offshore Peers We maintain our neutral stance on Chinese onshore stocks in a global portfolio, but do not yet recommend that investors buy in the onshore market in absolute terms. We also continue to recommend overweight Chinese government bonds versus stocks in the onshore market, and an underweight stance on Chinese offshore equities in both absolute and relative terms.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Dear client, This week we are sending you a joint Special Report with my colleague Chester Ntonifor, Foreign Exchange Strategist. The Special Report provides our outlook on the RMB. I trust that you will find the report very insightful. Best regards, Jing Sima China Strategist Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. The said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders   Forecast Summary