Trillions Returning to China: A-Shares Surge Ahead?

The months from September to November typically usher in a wave of uncertainty and volatility across global stock markets. With the Federal Reserve's recent rate cuts, investors across the world are closely monitoring the implications of these moves, especially within the U.S. political landscape, as they reverberate throughout the financial markets.

For investors in China, particularly those engaged with A-shares, the most pressing question is how these U.S. interest rate cuts will impact the Chinese stock market. As the Federal Reserve's September decision to lower rates became increasingly certain, discussions around the narrative that "U.S. rate cuts benefit the A-shares" gained traction. A rumor even sprang up suggesting that these cuts could lead to a trillion-dollar influx back into China, potentially buoying A-shares significantly.

This storyline seems straightforward enough: lower rates in the U.S. should ideally lead to increased foreign investment in A-shares, which has been lacking, especially regarding liquidity from high-risk investors. Many investors are hopeful that if foreign capital starts flowing back into A-shares, a significant market rally could indeed be on the horizon. Given the scarcity of incremental funds in the current A-share environment, this narrative appears appealing and aligns perfectly with investor sentiments.

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However, the reality may be more nuanced than it first appears. The narrative of "the East rising while the West falls" has been repeated many times over the past few years, often revealing stark contrasts with the outcome. This article aims to dissect the sentiment surrounding the trillion-dollar influx, exploring why it may not materialize to the extent some anticipate and its actual implications on domestic markets beyond just equities.

Recently, Stephen Jen, a prominent figure behind the "Dollar Smile Theory," made headlines in a Bloomberg interview. He suggested that Chinese enterprises could have amassed a substantial amount of dollars overseas in recent years, thanks to robust export activities. These dollars have generally been held in high-yielding dollar-denominated assets. With the Fed lowering rates, the allure of these high-yield dollar assets fades, opening the door for an anticipated return of at least a trillion dollars to China.

The narrative surrounding the potential for $1 trillion to return to Chinese assets found its roots within this framework.

The pivotal question arises: Do Chinese companies indeed possess a vast amount of foreign exchange accumulated overseas?

In fact, data suggests that the proportion of foreign exchange earned by domestic companies from exports is declining steadily. Although Chinese enterprises have managed to accumulate substantial overseas assets—primarily generated by export revenues—many are opting to keep these earnings abroad. In recent times, the Chinese economy has increasingly leaned on exports; with traditional export staples such as apparel, furniture, and appliances surging again and newer segments like electric vehicles and solar products also shining, trade tensions have prompted other nations to implement tariffs and other measures on Chinese goods. The upswing in export revenue has led to considerable gains in foreign exchange earnings.

Years ago, regulations mandated that exporters convert their foreign exchange earnings into renminbi; however, since January 1, 2011, companies now possess the flexibility to retain these earnings offshore without compelled conversion. As such, firms have been permitted to assess exchange rates and their own operational needs to decide how to utilize these earnings—be it converted into renminbi or invested offshore.

Given the ongoing depreciation of the renminbi in recent years, the appetite among exporting firms to convert their dollar earnings into renminbi drastically decreased. Analysis indicates that the ratio of currency settlements to total exports is declining, meaning a growing number of exporters seem reluctant to convert their dollar profits into renminbi, preferring instead to hold them in foreign currencies offshore.

This trend can be attributed to several factors. First, the weakening of the renminbi means that conversion to this currency would incur a loss. Second, the dollar has become a high-yielding asset, with deposit rates on dollar accounts occasionally exceeding 5%, a stark contrast to lower yields offered in renminbi. Lastly, there’s a growing demand for overseas investment among Chinese enterprises, and holding dollars simplifies these transactions.

Factors driving this trend have led to the accumulation of substantial dollar assets overseas by a variety of enterprises. Estimates suggest that the amount of unconverted funds held offshore could be around $1 trillion, reflecting a marked shift since before 2022. For instance, a calculation from CICC indicates that since 2022, there has been a decline of approximately 10 percentage points in the conversion rates of foreign exchange settlements relative to export totals, suggesting that the cumulative sum of these "non-converted" funds is around $933.2 billion from January 2022 to July 2024.

Should the Federal Reserve proceed with rate cuts, and should the renminbi enter a phase of appreciation, the current sentiment among companies holding substantial dollar amounts could indeed shift. A potential flux of capital back to renminbi could be facilitated as these companies expedite the conversion process to cater to needs such as repaying loans, disbursing bonuses, or meeting supplier obligations, insinuating the potential return of dollars to the Chinese economy.

This situation forms one of the core reasons behind the narrative of returning a trillion dollars to China. However, it’s important to note varying institutional predictions surrounding this amount—Macquarie Group anticipates over $500 billion, while ANZ sees the figure closer to $430 billion. Goldman Sachs estimates that when combining household-held dollar assets, the total could be no more than $600 billion, indicating that available currency for exchange would be even lower. Meanwhile, the head of rates and currency strategy at BNP Paribas for Greater China expressed skepticism, suggesting the figures could fall shy of the $1 trillion mark.

The divergence in projections reveals a general consensus on the idea of dollar influx returning, but opinions wildly differ on the anticipated scale.

Whether or not we see a robust conversion of dollars back into renminbi will heavily rely on the reasoning behind companies maintaining their dollar holdings, including considerations around exchange rate fluctuations, yields on dollar assets, and unique investment needs.

Examining exchange rates, for exporters, a depreciating renminbi is generally favorable since it enhances profit margins. Conversely, if firms anticipate appreciation of the renminbi, they would likely seek to convert dollars upon receipt to avoid potential exchange losses. Will the renminbi appreciate consistently? This is a complicated issue, thus a deeper analysis goes beyond the scope of this discussion; yet it's worth noting a key position from relevant authorities:

On August 9, the People's Bank of China (PBOC) released a report emphasizing the importance of monitoring cross-border capital flows and maintaining stable expectations to avoid creating unilateral predictability that can amplify volatility and risks surrounding exchange rates. Earlier, a Politburo meeting on July 30 indicated the desire to keep the yuan stable at a reasonable and balanced level.

Stabilization—whether in a strengthening or weakening direction—is ultimately preferable to authorities. Excessive appreciation could hinder exports, which could be a heavy burden for an economy reliant on such activities. Therefore, any signs of overvaluation or undervaluation would likely prompt the central bank to employ various measures to stabilize the currency. Hence, the expectation for significant appreciation in the renminbi seems unrealistic, and there’s even the possibility that the exchange rate could be nearing a balanced state.

Turning to the attractive yields on dollar holdings, many companies take advantage of the interest rate differential between converting to renminbi and retaining dollars. They tend to borrow in renminbi at lower rates while holding onto high-yielding dollar deposits.

For example, consider a publicly traded company in their 2023 annual report, disclosing nearly 90% of their cash holdings in dollar deposits. This company maintains day-to-day operations and cash flow primarily through short- to mid-term loans in renminbi, indicating that they are leveraging this interest rate differential to bolster income through dollar deposits.

By strategically ‘borrowing in low-yielding renminbi while keeping high-yielding dollar assets’, they secured 291 million yuan in interest income—a significant 169% increase from the previous year. While domestic loans yield some costs in interest, the overarching picture signals that interest income significantly surpasses costs.

Such scenarios imply that the differential between Chinese and American interest rates influences foreign currency transaction choices. Should this differential narrow or reverse, enterprises would likely shift toward renminbi holdings.

However, it appears unlikely that this rate gap will close anytime soon; a substantial interest differential between the U.S. and China is expected to continue, ensuring that the strategy of borrowing in renminbi and retaining dollar holdings prevails for quite a while.

Finally, due to overseas investment requirements and operational necessities, a notable portion of these overseas assets are increasingly transformed into fixed investments, expanding the scale of companies’ foreign investments.

The outbound investment landscape has transformed remarkably; in 2023, the number of Chinese companies directly investing in non-financial overseas enterprises hit 7,913—an impressive surge of 1,483 since 2022. The total amount of non-financial foreign direct investment reached 130.13 billion yuan, only trailing behind the high from the 2016 wave of overseas investment. Notably, regions such as Southeast Asia and Latin America have attracted significant outbound investments, solidifying their status as vital destinations for foreign funding, with substantial foreign exchange transforming into local fixed assets that are unlikely to flow back to China.

This situation resembles Japan’s past, often cited in discussions about its so-called “lost two decades.” Many studies argue that while Japan’s GDP stagnated, it effectively recreated a version of its economy overseas through globalization. While this conclusion remains debated, it undeniably illustrates that overseas assets are a crucial part of national wealth. The recent surge in Chinese enterprises pursuing overseas ventures exemplifies this dynamic.

In conclusion, while the notion of a trillion-dollar influx back into China is an appealing one, the practicalities suggest that such a scenario may not be as straightforward or optimistic as it appears. The projected return of funds to A-shares may well be more imaginative than actual, with excessive optimism carrying inherent risks.

However, this does not dampen my overall optimism regarding the A-shares market. Current policies encouraging positivity and evidently improving fundamentals have been overshadowed by pervasive pessimism. Both overly optimistic and excessively pessimistic stances harbor their own risks.

Selling during a 'frenzied market' is akin to tricky navigation, as is buying amid 'indifference.' Yet these circumstances often represent the most prudent choices.