New Equilibrium in China's International Balance of Payments

It is an understatement to say that 2020 has been an extraordinary year. Covid-19 has resulted in a massive death toll and sickened millions more. It has delivered a body blow to the world economy and brought turmoil to international financial markets. Despite the daunting external environment，however，China's economy has been able to regain its footing. Its foreign exchange market has managed to operate smoothly and the nation’s balance of payments position has posted surprisingly positive results.

Chen Zhiwei，editor-in-chief of the Foreign Exchange Research Center of the State Administration of Foreign Exchange，discusses these circumstances and what has been called a new equilibrium in the balance of payments with Wang Chunying，deputy director of the State Administration of Foreign Exchange. Wang point out that China's better-than-expected situation is attributable to its domestic support for the economy and the market. China is also likely to see its foreign exchange market operating smoothly in the future. The following is an edited version of their wide-ranging discussion.

New Equilibrium

Chen Zhiwei: Since the beginning of this year，the world economy has been hit hard by the spread of Covid-19 and global financial markets have been buffeted by repeated waves of turmoil. China has adopted a balanced approach to containing the pandemic and preserving economic and social development. This has ensured a recovery of the domestic economy and promoted an equilibrium in the balance of payments. What is your assessment of the foreign exchange situation over the year?

Wang Chunying: Since the beginning of 2020，Covid-19 has dealt a sharp blow to the global economy and world financial markets. However，with the  support of China's strong economic fundamentals，we have achieved a better than expected equilibrium in the international balance of payments. At the same time，the renminbi exchange rate has been steady and foreign exchange market transactions have displayed a certain rationality. Two-way cross-border investments remain active. Specifically，these achievements are reflected in the following areas:

First，China has maintained basic equilibrium in the international balance of payments and exchange reserves have been rising steadily. In the first half of this year，China's current account surplus was US$76.5 billion or 1.2% of the nation's gross domestic product. This was a reasonable level. Taking into account the relatively large surplus in the trade in goods and the comparatively low deficit in the trade in services since the third quarter，the current account is expected to remain basically balanced and show a small surplus this year. China's foreign exchange reserves stabilized at over US$3.1 trillion as of the end of September，an increase of US$34.6 billion compared with the end of last year.

Second，the renminbi exchange rate has become more flexible，and the currency has put in a solid performance against major currencies. The renminbi exchange rate has experienced both rises and falls in 2020，showing two-way fluctuations. The one-year implied volatility in the domestic options market averaged 5.0% and the range between the highest and lowest price reached 7.5%. That is within a reasonable and proper range. Over the first three quarters of the year，the spot exchange rate of the renminbi against the US dollar rose 2.3%. Over that same period，the dollar index fell 2.5%，the euro rose 4.5% against the dollar and the emerging market currency index slid 12.2%. It's obvious that the performance of the renminbi was significantly stronger than that of other emerging market currencies，and it held steady at a moderate level compared to currencies of most developed countries.

Third，market behavior became more rational and market expectations remained stable. Statistics of exchange settlements and sales show that market entities mostly "settle exchange at a good price and purchase at a low price," indicating that market entities have a growing awareness of controlling exchange rate risks. As for indications from the forward and options markets， there is no sign of a one-way trading consensus and the overall expectations for the exchange rate are relatively stable.

Fourth，two-way cross-border investments remained active and capital flows were steady and orderly. The investment enthusiasm of overseas investors was undiminished. According to statistics from the Ministry of Commerce，inbound investment by non-financial foreign investors reached US$103.3 billion in the first three quarters，for a year-on-year increase of 2.5%. SAFE data also showed that during the same period foreign investors’ net holdings of domestic stocks and bonds increased by US$132.1 billion for a year-on-year rise of 47%. At the same time，outbound investment by domestic entities slipped back. During the first three quarters，our outward foreign direct investment by non-financial enterprises was US$78.9 billion，down 2.6% from the same period last year.

Chen Zhiwei: On the whole，China's cross-border capital flows were steady over the first three quarters and supply and demand on our foreign exchange market also remained basically balanced. Today，the world has not yet shrugged off the impact of Covid-19，and China will need to confront an unstable and uncertain external environment. In view of these facts，what do you see ahead for our foreign exchange market?

Wang Chunying: China's foreign exchange market is expected to continue its stable operation. First，we took the lead in containing the coronavirus and focusing on getting our economy back on track. Manufacturing，services，and consumption have all provided strong support in this process and will  continue to play a key role in stabilizing market expectations and enhancing market confidence. China has also been persistently advancing a two-way opening of its financial market. It remains committed to facilitating trade and investment liberalization and creating a conducive environment for two-way cross-border capital flows. Meanwhile，China has been speeding up efforts to foster a new development paradigm with domestic circulation as the mainstay and domestic and international circulations reinforcing each other. New mechanisms are being put in place to build an open economy of a higher standard and further improve the quality of two-way cross-border investment. And the renminbi is playing its role in balancing the economy and the balance of payments. The two-in-one management framework of “macro prudence + micro supervision” in the foreign exchange market is constantly improving.

Chen Zhiwei: In the past，China’s balance of payments showed “twin surpluses” in the current account and on the non-reserve financial account. That resulted in a rapid rise in foreign exchange reserves. China more recently experienced a deficit in its non-reserve financial account while the current account maintained a surplus. This resulted in a decline in its foreign exchange reserves. As we all know，people are generally very sensitive about deficit items，so how should we view the relationship between the current account and the non-reserve financial account in the context of today's balance of payments situation?

Wang Chunying: China's balance of payments position has shown a new equilibrium in recent years – instead of fluctuating along with major balance of payment items，our foreign exchange reserve has remained basically stable.

First，there has been an overall pattern of an autonomous balance with basically stable reserve assets. Against this kind of background，the current account and non-reserve financial account will be mirror images of each other. This means that when the current account has a surplus，the non-reserve financial account will show a deficit，and vice versa. In a word，the two will maintain a basic equilibrium in the balance of payments.

Next，it is normal to have both surplus items and deficit items under an autonomous balanced pattern. Moreover，a deficit does not necessarily equal risk. For example，during the first half of this year，China's current account had a surplus while the non-reserve financial account had a deficit. However，there was no external debt deleveraging，and foreign direct investments，securities investments and other investments have all seen a net inflow. Deficits were mainly attributed to the increase in various types of overseas investments，reflecting the addition of our market entities' overseas assets. First，due to diversified asset allocation needs，residents have increased their investments in offshore securities – mainly in the Hong Kong stock market. Second，overall outward direct investments have been promoted in an orderly manner. Third，by reason of the surplus on the current account and foreign direct investments，bank deposits and loans have increased and domestic foreign exchange liquidity was abundant. Therefore，as I said earlier，a deficit does not necessarily mean risk.

Last，China's present current account condition is quite reasonable and desirable. It is likely that the overall pattern of basic equilibrium will continue  in the future. During the recent years when our international balance of payments has come to an autonomous balanced phase，the current account has generally been balanced with a slight surplus. This is the result of the domestic economic transformation and upgrading as well as economic structural optimization. It reflects our new development paradigm with domestic circulation being the mainstay and the two circulations reinforcing each other. Meanwhile，China's economic structural optimization and the upgrading of the manufacturing sector will also play a fundamental role in maintaining the basic balance on our current account. That is to say，China's international balance of payments has the foundational conditions to maintain a reasonable and desirable situation in the long run.

Gains in Foreign Exchange Market Construction

Chen Zhiwei: Over the years，our foreign exchange market has made steady progress. Breakthroughs have been made in many important areas since the beginning of the reform and opening program. Could you breifly describe the key points in the development of our foreign exchange market and the progress we've made in the reform effort?

Wang Chunying: Over the past 40 years，China's foreign exchange market has developed from scratch. A market system aligned with the socialist market economy was initially established，playing an important role in macro-control，resource allocation，exchange rate formation and risk management. Especially since 1994，the establishment of a unified foreign exchange market has enabled national foreign exchange transactions to be incorporated into the interbank foreign exchange market through bank exchange settlements and sales system. This has ensured a reasonable flow of foreign exchange resources across the country based on market conditions.

In 2005，China began to implement a managed float exchange rate system based on market supply and demand and adjusted with reference to a basket of currencies. This meant our foreign exchange market had entered a new development level. In addition to the traditional spot and forward exchange transactions，products traded gradually expanded to include foreign exchange swaps，currency swaps and options. A basic product system for the international market was in place.

Trading entities have been expanded from banks to non-bank financial institutions，non-financial enterprises and various overseas institutions. This means there has been progress in boosting the depth and breadth of the foreign exchange market. With a market-oriented and standardized development as it was envisioned by regulatory authorities，China's foreign exchange market has gradually been integrated into the international market. In 2019，the renminbi’s foreign exchange trading volume in the domestic market reached US$29.1 trillion，or 137 times the level of 1994. At the same time，with the continuous progress of renminbi internationalization and the development of the offshore renminbi market，there has been a strengthening of the onshore renminbi trade. The two constitute an international renminbi foreign exchange market system. According to statistics from the Bank for International Settlements，the renminbi has become the eighth most traded currency on global foreign exchange markets.

Chen Zhiwei: What has SAFE done to advance the development of China's foreign exchange market during the 13th Five-Year Plan period?

Wang Chunying: During the 13th Five-Year Plan period，SAFE has been actively promoting a deepening of foreign exchange market reform，and has achieved fruitful outcomes in terms of products，infrastructure construction，and market self-regulation.

The Notice by the State Administration of Foreign Exchange on Foreign Exchange Issues Concerning the Improvement of Forward Foreign Exchange Settlements and Sales was issued to allow forward settlements and sales of foreign exchange to be settled in fu