By Zhennan Li & Brad Gibson
China’s currency, the renminbi (RMB), remains strong even though many of the factors that have influenced its performance over the past two years have weakened. To understand the near-term outlook for the currency, investors should uncheck the nuanced dynamics that drive it now.
While China emerged from the first wave of COVID-19 ahead of other countries, its stronger growth rates, higher interest rates and an export-led recovery have led to increased demand for RMB. Now that these pillars of support have eroded, the currency’s recent strength has unnerved investors.
It persists even as the spread between 10-year US Treasuries and Chinese government bonds has narrowed, with Treasury yields rising (making them more attractive to buyers) and Chinese yields rising. decrease.
For example, the “yield spread” between US and Chinese 10-year bonds has fallen from a record high of 2.5% in November 2020 to near zero recently.
This fueled expectations that the RMB would weaken against the dollar on the basis that the “carry,” or extra yield available in China relative to other markets, had disappeared. As Chinese bonds would see reduced demand from foreign investors, the RMB would see less support. Instead, however, the RMB appreciated against the dollar from CN¥6.6 to CN¥6.35 (Display).
RMB Appreciates, Even as US Yields Rise
Yield spread (10-year Chinese government bond minus 10-year US Treasury bills) and exchange rate (US dollar to Chinese yuan)
Until April 1, 2022
Source: Wind and AllianceBernstein (AB)
It is also surprising that although it has historically been relatively closely correlated to the US dollar trade-weighted index, the RMB has deviated sharply from it recently. And the People’s Bank of China (PBOC), which in the past has intervened to moderate the strength or weakness of the RMB, did not react vigorously on this occasion.
Unraveling these puzzles is key, in our view, to understanding the near-term outlook for the RMB.
Interest rate differentials have a limited impact
In theory, it makes sense that interest rate differentials, as measured by the yield spread between the Chinese and US bond markets, would have some impact on the USD-CNY exchange rate.
However, statistics show that the historical relationship between Chinese and US yield spreads and the USD-CNY is not very strong compared to similar relationships elsewhere – a reflection, in part, of the fact that China is still among the least financially open economies in his country. per capita income bracket.
Similarly, there is no clear link between inflows of foreign funds into the Chinese bond market and yield differentials. Inflows into Chinese bonds increased from April 2021 through the end of the year, even as US yields, as shown by the narrowing of the yield spread, rose relative to Chinese yields (Display).
Yields aren’t the only driver of bond inflows
Foreign inflows into Chinese government bonds and yield spread (Chinese 10-year government bonds minus 10-year US Treasuries)
Until February 28, 2022
Source: Haver Analytics, Wind and AllianceBernstein
Clearly, factors unrelated to yield differentials helped support inflows. These would have included the structural demand from foreign investors to allocate to RMB assets and the demand for Chinese government bonds caused by their inclusion in the FTSE World Government Bond Index in November 2021.
Foreign capital inflows have fallen sharply since February 2022. Although the yield spread may have been a factor, the low net supply of Chinese government bonds and turmoil in global markets amid the Russian crisis -Ukrainian probably also played a role.
Market forces weaken USD-CNY correlation
Currently, there are two elements to the mechanism by which China establishes the daily USD-CNY “central parity”: market forces (which can be measured by comparing the closing spot price with the previous day’s fixing price) and broad or trade-weighted parity. US dollar index. The USD-CNY spot rate may move within a 2% band around the fixing.
Historically, the USD-CNY fixing and the USD index have been closely correlated. Recently, however, they have diverged (Display).
The RMB “decouples” from the US dollar
Exchange rate (US dollar to Chinese yuan) and broader US dollar index
Until April 1, 2022
Source: Vent and AllianceBernstein
Much of the divergence was triggered by market forces, which is reflected in the fact that in recent months the USD-CNY close rate has been consistently above the previous day’s fixing rate.
One of the main contributors has been the large trade surplus which in the fourth quarter of 2021 averaged $84 billion per month and reached a monthly record of $94 billion in December. The surplus remained high at the start of 2022, seasonally adjusted.
The impact extends to the entire basic balance of payments (BBOP), including the current account balance, net direct investment and net portfolio flows. While portfolio investment inflows have benefited from the opening of Chinese bond and equity markets, current account and direct investment remain stronger. China’s current account surplus has increased significantly over the past two years on the back of strong growth in goods exports and a declining services trade deficit (Display).
A strong increase in the balance of payments boosted the RMB
Broad Basic Balance of Payments (NET) and Change in Exchange Rate (US Dollar to Chinese Yuan)
Until December 31, 2021
Source: Vent and AllianceBernstein
Overall, a significant rise in the BBOP was a major factor in the rise of the RMB.
PBOC promotes flexibility
In our view, the PBOC’s lack of intervention is less of a headache than it appears. It has been several years since the central bank took such action (for example, to defend the currency’s competitiveness in export markets), and it explicitly disavowed its intention to do so again.
The PBOC has significantly increased the flexibility of the RMB in recent years, in response to more volatile capital flows and to increase the independence of monetary policy. Partly because of this, the CNY is increasingly influenced by market forces.
The PBOC is concerned about the USD-CNY, but rather than changing direction or defending a “magic level”, the central bank is more concerned about the potential build-up of pro-cyclical and speculative factors in the market, which could occur when the rate of appreciation or depreciation is too rapid.
Importantly, direct intervention through foreign exchange reserves has been sharply reduced and the PBOC has preferred indirect policy tools such as macroprudential measures to curb currency excesses.
All things considered, stability is likely
In this context, what is the short-term outlook for the RMB?
While all of the above factors play a role, the most important, according to our research, is BBOP. The current account surplus is expected to moderate this year, but we expect it to remain positive and significant. Foreign direct investment (FDI) inflows have been trending upward since 2015, despite a slowdown during the 2018-2019 trade war, and FDI data earlier this year, along with industry surveys, suggest that they should remain stable.
Bond inflows could come under pressure from the geopolitical crisis and narrowing credit spreads, but the index inclusion effect and potential increase in reserve allocation to Chinese government bonds could contribute to support flows. Equity inflows could benefit now that the government – following the stock market sell-off caused by macroeconomic uncertainties and the large equity outflow to the north in early March – aims to improve communication with investors. markets, policy coordination and transparency.
These factors, together with an expected improvement in growth fundamentals over the coming quarters, should be positive for the RMB.
In terms of yield spreads, while the 10-year US Treasury yield may rise further in the coming months, we expect the yield on comparable Chinese government bonds to rise as well, limiting the possibility that the yield gap narrows further. Although narrower rate differentials may put some pressure on the CNY, in our view it is unlikely to dominate its direction.
Considering all these factors, we expect the RMB to remain broadly range-bound and stable against the US Dollar in the near term.
1 CN¥ = Chinese yuan, the unit of account of the RMB currency.
The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. Views are subject to change over time.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.