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firms can be naturally slowed by internal directives. Bad outflow such falling CNY deposits among foreign subsidiaries of China banks can also be managed. However, it is the inherent speculative and unstable nature of domestic capital flight that we characterize as ugly flows that poses the greatest risk to the central bank. Regressions and scenario implications for EM FX We used a simple regression to quantify the impact of the RMB depreciation on key EM FX: BRL, RUB, INR, TRY, and ZAR'. We analyzed two cases: 1) Base case — USD/CNY rises to 7.25 and market volatility, which we use the VIX as a proxy, is unchanged from its current level; 2) Risk case - USD/CNY rises to 8.00 and intense RMB depreciation expectations cause market volatility to rise by three standard deviations. We find: e The most vulnerable currencies to RMB depreciation are ZAR, RUB and TRY (Chart 58). The impact of RMB depreciation on BRL and INR is small. This is probably due to stronger idiosyncratic factors for BRL and INR in recent years. « Anincrease in market volatility associated with USD/CNY rising to 8.00 would raise the depreciation of EM FX by 1ppt (BRL)-11ppt(ZAR) relative to our 7.25 baseline. ¢ In our base case of USD/CNY rising to 7.25 by end-2017, the market is overpricing depreciation pressures from the RMB on EM currencies. This partly reflects other factors have more sway over market expectations at the time of writing, such as implications of the US elections outcome. e Inour risk case of USD/CNY rising to 8.00 and high volatility, there is room for additional depreciation in the ZAR and RUB (Chart 58). Chart 58: EM FX sensitivity to RMB and market volatility Chart 59: Scenario analysis of EM FX against market pricing 5 0 5 -10 a a a Oo -10 45 15 -20 a 20 ZAR RUB TRY BRL INR ZAR RUB TRY BRL INR WForecast change vs SDR, % (Volatile markets and USD/CNY at 8.00) m Forecast change vs SDR, % (Volatile markets and USD/CNY at 8.00) Forecast change vs SDR, % (Same volatility and USD/CNY at 7.25) m Forecast change vs SDR, % (Same volatility and USD/CNY at 7.25) Forward implied change by end-2017, % Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg Can bond and equity inflows save the day? Not in the near term Given the problematic issue of capital outflows and limited efficacy of moderate capital flows, another solution could be to attract more foreign portfolio inflows into China’s sizable bond and equity markets. More favorable investment policies geared to overseas investors investing in China’s interbank bond market reveal a clear policy intention to open up China’s financial market. As a result, expectations are rising for China to be included in global bond indices. However, the following key obstacles for index inclusion remain, although reasons vary depending on the index: 1) lack of full accessibility: currently qualified investors only include medium and long-term investors while hedge funds are excluded; 2) insufficient clarification on requirements of fund remittance; 3) lack of clarification on tax issues; 4) lack of accessibility to onshore FX/rates hedging tools. Back from our 2016 China Conference, we believe allowing foreign private investors to access onshore repo, onshore FX swap and forwards would be the next steps to follow. T Our dependent variable is the weekly changes of SDR/EM; our independent variables are the weekly changes in the SDR/EUR, SDR/CNY, SDR/USD and the VIX index, and a constant. Natural logarithms were taken for all variables and our sample period is Jan’14-Nov’16, when the start of the RMB depreciation trend. We base our currencies against the SDR to define their value (See Assessing China’s Exchange Rate Regime, Frankel and Wei (2007) for a detailed explanation.). To compute the forecast change in each currency, we use our global FX forecasts to obtain our independent variables. 34 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014764