The renminbi exchange rate against the dollar (CNY-USD) fell from 6.36 to 6.78 (a drop of 6.6%) in just a few weeks between the end of April and the beginning of May (see chart 1) . What happened?
There are many reasons:
- Significant portfolio outflows. Foreign investors sold a net $7.9 billion of onshore China bonds at the end of April, according to Nomura Global Markets, offsetting $4.6 billion net inflows into onshore China equities via Stock Connect programs;
- Onshore corporate coverage. Importers bought more foreign currency for payments (assuming foreign currency will become more expensive) and exporters hoarded foreign currency so they could record higher profits in renminbi terms;
- US dollar strength. Aggressive US Federal Reserve policy tightening and safe-haven flows driven by growing risk aversion pushed the US dollar’s trade-weighted exchange rate to nearly two-decade highs;
- Sharp depreciation of regional currencies, especially the Japanese yen. This caused the renminbi’s trade-weighted exchange rate (CFETS) to spike significantly, prompting the People’s Bank of China (PBoC) to adopt a weak RMB-USD cross rate policy to halt further appreciation of the CFETS ( see below for more information).
What drives portfolio exits?
- The interest rate differential between Chinese and US government bond yields has narrowed to almost zero due to the divergence between monetary policies in China and the US;
- Market pessimism about growth prospects and asset markets in China. Investors worry about the country’s zero Covid policy and perceive insufficient policy support to stabilize economic growth;
- Regulatory risk as the United States forces Chinese stocks to withdraw from US exchanges. This led to a sell-off in Chinese stocks not only in the United States, but also in Hong Kong and the Chinese A-share market.
Has China switched to a policy of devaluation?
No. The PBoC has a stable exchange rate policy targeting primarily the CFETS index, using the RMB-USD cross rate as a balancing factor, all other things being equal. Under normal market conditions, when the CEFTS rises, the PBoC will guide the RMB-USD lower to offset some of the upward pressure on the CFETS basket, and vice versa.
However, contrary to market perception, China is not just aiming for a stable RMB-USD cross rate. It only prioritizes stabilizing the RMB-USD when the market is volatile, as the cross rate is more visible to the public than the CFETS.
The sharp depreciation of other Asian currencies, particularly the Japanese yen, against the strength of the US dollar has driven the CFETS sharply higher since late 2021 (see Figure 2). The Chinese authorities are uncomfortable with this. While the dollar has strengthened recently, the PBoC tolerated further RMB-USD weakness to ease the appreciation pressure on the CFETS; RMB-USD weakness is not a devaluation move.
The PBoC wants the renminbi to show swings back and forth around its “fix” as part of the bank’s currency reforms. It will intervene in the market to eradicate any one-sided speculation.
What are the PBoC’s intervention tools?
Capital controls are the last resort. Other common tools include, but are not limited to:
- Direct intervention (by buying and selling currencies in the market) and verbal intervention (including giving policy directives to banks on currency trading);
- Modification of reserve requirements for foreign currency deposits with banks, thereby adjusting the supply of foreign currency in the market. For example, at the end of April, the PBoC reduced banks’ foreign exchange reserve requirements from 1% to 8% (increasing the supply of US dollars by 10 billion) in an attempt to slow the rate of depreciation of the RMB-USD;
- Use the countercyclical factor to modify the daily fixing;
- Change offshore lending limits from domestic banks to influence renminbi supply;
- Raise the cost of short selling the onshore renminbi by increasing the risk reserve requirement for banks’ forward foreign exchange positions.
Will the renminbi fall further?
It is likely that the short-term depreciation pressure on the renminbi is likely to remain strong, namely:
- Hedging by Chinese companies against expected further renminbi weakness;
- Continued political divergence between China and the United States;
- Uncertainty over the US regulatory risk linked to the delisting of Chinese equities, leading to portfolio outflows;
- Bad market sentiment with no end in sight for zero-Covid policy;
- Greater tolerance of the PBoC to a lower RMB-USD rate to stop the upward pressure on the CFETS exchange rate;
- Negative sentiment on global growth (Chinese export growth dampening) thanks to aggressive policy tightening by major central banks and continued Russia-Ukraine crisis
Basic balance supports
Assuming that all other exchange rates in the CFETS basket remain unchanged against the USD, a drop in RMB-USD to 7.0 would take the CFETS rate to around 100 from the current level of 103-104. This suggests that the probability of the RMB-USD falling to 7.0 in the near term is high.
Looking beyond the short term, China’s fundamental equilibrium core support for the renminbi is still strong. China’s current account balance is in surplus and the country continues to benefit from net foreign direct investment (FDI) inflows.
Once sentiment on China improves, net portfolio inflows should return. Given the existing positive fundamental support, these factors should allow the renminbi to rally next year.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience.
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.
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