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Table 5: Scenario analysis of China’s 2017 FX reserves (yellow denotes lower reserves/ blue higher) Trade balance, USDbn 100 150 200 250 300 350 400 450 500 300 2,885 2,935 2,985 3,035 3,085 3,135 350 2,835 2,885 2,935 2,985 3,035 3,085 3,135 400 2,185 2,835 2,885 2,935 2,985 3,035 3,085 3,135 450 2,135 2,185 2,835 2,885 2,935 2,985 3,035 3,085 3,135 500 2,135 2,835 2,885 2,935 2,985 3,035 3,085 550 2,685 2,835 2,935 2,985 3,035 600 : 2,635 : 2,885 2,935 2,985 Capital outflow, USDbn 650 2.835 2885 2935 700 85 2.835 2.885 750 2 835 800 2.68 785 850 | 2685 2.735 900 me 2635 2,685 Source: BofA Merrill Lynch Global Research, Bloomberg. 2016 rate is annualized from the first 3 quarters of data. Table 5, above, shows a scenario analysis of China’s FX reserves in 2017 under different trade balance and capital outflows. The analysis makes two assumptions. The first assumption is all the changes in the Balance of Payment’s (BoP) reserve assets are reflected in the headline FX reserves figure. The second assumption is that the income balance is USD -36bn, which was derived from the annual rate since 2015. We believe a decline of FX reserves to USD 2,600bn to USD 2,900bn would only be a problem for China if it attempted to implement a “fixed exchange rate” without capital controls. Such an FX regime requires heavy FX intervention and would put downward pressure on its FX reserves, making this FX regime choice no longer tenable for China. The IMF’s framework for calculating adequate FX reserves is based on whether there are capital controls and whether the currency operates on a fixed or floating exchange rate regime (Table 6). The latest readings show a fixed exchange rate regime without capital controls in China would require USD 2,911bn of FX reserves, which probably won't be achieved, as shown in Table 1. Meanwhile, a floating exchange rate regime with no capital controls would require USD 1,618bn of FX reserves. Fewer FX reserves would be needed to manage a floating currency that would adjust freely to capital flows. This reinforces the view that the CNY is moving toward a more flexible FX regime as its FX reserves are depleted (barring a draconian step capital control measures). Skeptics may counter that China could always ratchet up capital controls to reassert control over its currency. However, the efficacy of this is questionable. The experience of 2016 shows that in spite of more capital controls introduced in late 2015 (e.g., onshore window guidance restricting the sale of FX by onshore banks) capital outflows have continued along with FX reserve depletion, albeit at a slower pace. Ultimately, this means China’s ability to exert control over the CNY is being eroded, while the risk of more CNY volatility is rising. This is our scenario for 2017, with the tail risk that “ugly flows” or illicit capital flight due to domestic financial stability concerns could drive sharper CNY depreciation and FX reserve depletion. It is under this tail risk scenario that the temptation for draconian capital controls becomes a danger. For this reason, we believe it will be important to monitor the nature of the capital outflow and not just the size of the outflow. Good outflow such as Overseas Direct Investment by state-owned Table 6: China reserves adequacy recommendations based on IMF guidelines Latest, Capital control No capital control USDbn Fixed Floating Fixed Floating Weight, % USDbn Weight, % USDbn | Weight, % USDbn Weight, % USDbn Short-term debt 167 30 230 30 230 30 230 30 230 Other liabilities 961 20 192 20 192 20 192 15 144 Exports 2,156 10 216 10 216 10 216 5 108 Broad money 22,128 ) 1,136 25 568 10 2,213 5 1,136 Recommended reserves 1,774 1,206 2,911 1,618 Source: BofA Merrill Lynch Global Research, Bloomberg, SAFE Bank of America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 33 Merrill Lynch HOUSE_OVERSIGHT_014763