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Stress testing CNY Claudio Piron Yang Chen Merrill Lynch (Singapore) Merrill Lynch (Hong Kong) claudio.piron@baml.com ychen8@baml.com Gabriele Foa Ronald Man MLI (UK) Merrill Lynch (Hong Kong) gabriele.foa@baml.com ronald.man@baml.com SiRESS testing CNY We stress test China’s FX reserves to capital outflows and warn of a potential USD520bn fall in FX reserves in 2017, translating into higher CNY volatility. « We also look at broader EM FX sensitivity to CNY depreciation and find ZAR and RUB most vulnerable. e We examine if bond index and MSCI inclusion could significantly offset outflows, but are doubtful for now. CNY - anything left in reserve? We forecast USD/CNY to rise to 7.25 by year-end 2017 based on sustained capital outflows from China and the People’s Bank of China (PBoC) allowing the exchange rate to depreciate accordingly. A key change in the PBoC’s new FX regime, announced in August 2015, is to raise the influence of market forces over the exchange rate. We showed that not all outflows are created equal. Some outflows are good and reflect structural changes in China’s economy and liberalization of China’s financial account; some outflows are ugly in the sense they represent illicit outflows. Yet both types of outflows are influenced by policy uncertainty in China, which we showed can explain a significant amount of capital outflows through Chinese purchases of overseas assets. The impact of capital outflows alone on China’s FX reserves is negative. A decline in FX reserves is also associated with an increase in volatility of the RMB (Chart 57). But the negative impact on FX reserves may be offset by China’s trade balance. If China’s trade balance and capital outflows are similar to that recorded in 2015 and 2016, then China’s FX reserves would be between USD 2,600bn and USD 2,900bn in 2017. This represents a fall of USD520-220bn given current FX reserves of USD3,120bn and would amount to China having diminished control over its currency and higher CNY volatility - assuming no dramatic changes to capital controls. Chart 57: China FX reserves (down) and RMB volatility (up) 4,000 1,500 3,750 1,250 3,500 1,000 3,250 750 3,000 500 2,790 290 2,500 0 2011 2012 2013 2014 2015 2016 === China FX reserves, USDbn === USD/CNY 1Y rolling standard deviation, pips (RHS) Source: BofA Merrill Lynch Global Research, Bloomberg 32 _ Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014762