EFTA01459585.pdf

15 January 2016 Global Economic Perspectives: China's evolving FX policy Our colleagues Zhiwei Zhang and Li Zeng recently offered at least a partial Adjusting for supply chain explanation. We have for years emphasized that one needs to consider Asian influences, China's real exports from the perspective of regional production networks. An emerging literature demonstrates that exchange rate elasticities for exports are lower the exchange rate has more integrated countries are in supply chains. Zhiwei and Li re-calculated appreciated far less than China's real effective exchange rate adjusting the weights for the importance conventional measures of export processing. Chinese exports benefit from a depreciation of the suggest. Korean won, for example, to the extent that they embody imported components from South Korea. Recalculating the REER to incorporate such supply chain effects, they find that China's real effective exchange rate appreciated only 19% between 2010 and 2015 - and hardly at all for its high- tech export sectors - which is much less than the 31% appreciation of the BIS' conventional export-weighted REER. Many exporters, of course, would welcome a depreciation and it may be that as the proprietor of the final stages of many regional production networks China's exchange rate versus the USD and EUR may be more important to regional export growth than that of South Korea or Taiwan, for example. But with a record trade surplus of USD602bn last year and rising we don't see a competitiveness-based need for a weaker currency. What do we expect from here? That doesn't mean we don't see the currency continuing to depreciate. Zhiwei We still expect further RMB Zhang expects the exchange rate to reach 7.01USD this year and our FX deprecation, just hopefully strategist Perry Kojodjojo thinks that could come earlier rather than later. A simple interest-rate based argument - the Fed expected to raise rates three less rapid than in recent times this year and China expected to cut twice - suggests 7.0 is a very weeks. plausible forecast. Figure 9: interest rates and the tityle. 5.0% 6.8 4.0% 3.0% 2.0% 1.0% 7.0 0.0% -1.0% 7.4 -2.0% 7.8 -3.0% 2Y bond spread between US & China -4.0% USD/CNY spot (Inverted. RHS) 8.2 06 07 08 09 10 II 12 13 14 15 16 Sans IlIcenibeep Piety (Pax/ Ogaw.A• Bee But the pace of depreciation need not be as rapid as it has been. With an evolving strategy for managing the exchange rate the authorities have both surprised and confused investors. It is not clear what their intentions are beyond continuing to allow more flexibility in the exchange rate. Nor should investors expect perfect clarity - few countries that don't have fixed exchange rates are perfectly transparent. So investors and policymakers will both continue to learn how this new regime works. As capital outflows hopefully subside - and we think it's reasonable to expect they will -- there would be less pressure on the currency to depreciate. • See Zhang, Zhnvet and Ii Zang. "A new REER index lot AMR," Deutsche Rank Rematch. Jan. 5, 2016 Deutsche Bank Securities Inc. Page 7 CONFIDENTIAL - PURSUANT TO FED. R. CRIM. P. 6(e) DB-SDNY-0 120091 CONFIDENTIAL SDNY_GM_00266275 EFTA01459585