The impact of Brexit on China
Print Edition
BREXIT was a major shock to the global financial market and the global economy. The full impact is still to unfold, as the exiting procedure could be complicated and could take multi-year negotiations. In our assessment, the near-term economic impact of Brexit on China is likely to be limited, but it could have important implications on China’s exchange rate policy operation, the strategy in capital account liberalization, and monetary policy operation.
The existing exchange rate regime, in which daily fixing is jointly determined by trade-weighted index (known as TWI) and closing spots on the previous day, has gradually gained credibility and mitigated capital outflow and Chinese yuan depreciation pressure in the past three to four months. In practice, the new regime looks like not a strict basket peg, in which TWI is relatively stable on daily basis to offset volatility in major currencies, but over time TWI has exhibited a downward slope.
The increasing credibility of the new regime has benefited from much improved communication from the central bank, the consistency between policy elaboration and daily fixing practice, strengthened rules to contain capital outflows, as well as a weak US dollar environment.
Brexit could potentially affect the dynamics of major currencies: for example, right after Brexit, the pound and euro depreciated against the US dollar significantly but the yen appreciated. This could lead to larger volatility in the global foreign exchange market, likely an upward bias to our current forecast of relatively stable US dollar index for the rest of the year. In such a scenario, while we expect the People’s Bank of China will not deviate from the current exchange rate regime, the strategy could be fine-tuned. In particular, Chinese yuan TWI will likely be stable for the rest of the year, or the downward slope as observed in recent months could become much flatter, to avoid large Chinese yuan depreciation against the US dollar.
On June 27, the PBOC set the daily fixing at 6.6375, versus 6.5776 on Friday. We maintain our forecast of US dollar/Chinese yuan at 6.75 at the end of 2016, but this is more likely to be driven by US dollar strength rather than TWI depreciation.
Risk-off related to Brexit could trigger concerns about capital outflows from emerging markets. In China’s case, capital account is not fully liberalized, but capital outflow has been a major policy concerns in recent years. Brexit could strengthen the asymmetric strategy in capital account openness in China, for example, continue to make further progress to encourage capital inflows, but cautious in moves on capital outflows.
Brexit also reinforces our view that China’s monetary policy will stay neutral rather than shift towards tightening. There will be the question whether monetary policy will see a major shift from being accommodative in the first quarter to tightening going forward.
In our interpretation, the adjustment is to remove expectations on monetary stimulus, but “monetary policy will be appropriate” implies that monetary condition will not reverse the direction toward tightening, and it could have a slight easing bias if the macro situation weakens again as we expect one 25 basic point interest rate cut in the fourth quarter when the growth slows down to 6.3 percent quarter on quarter.
In particular, after Brexit, major economies are biased towards additional monetary easing or slower pace in monetary policy normalization.
Lastly, the trade impact of Brexit on China tends to be limited. The United Kingdom only accounts for 2.6 percent of China’s exports; while the European Union is more important, accounting for 13 percent of China’s exports.
However, Brexit is unlikely to directly change the bilateral trade relationship between China and the EU or the UK, instead it is via indirect impact, for example, by economic slowdown in the UK and the EU, and it could be offset by their moves of seeking closer trade relationship with China and the rest of the world as a risk-management strategy.
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