In recent weeks, the renminbi has depreciated significantly against the US dollar. Chi Lo, our senior market strategist in Hong Kong, explains what is happening and give his outlook for the Chinese currency.
The renminbi exchange rate against the dollar (CNY-USD), fell from 6.36 to 6.78 (a 6.6% drop) in just a couple of weeks between the end of April and early May (see Exhibit 1). What happened?
There are a number of reasons:
- Large portfolio outflows. Foreign investors sold a net amount of USD 7.9 billion of onshore Chinese bonds in late April, according to Nomura Global Markets, offsetting the net inflows of USD 4.6 billion into onshore Chinese stocks via the Stock Connect programmes;
- Onshore corporate hedging. Importers have been buying more foreign currency for payments (on the assumption that foreign currencies will become more expensive) and exporters have been hoarding foreign currency so they can book higher profits in renminbi terms;
- US dollar strength. The US Federal Reserve’s aggressive policy tightening, and safe-haven flows due to increasing risk aversion, have pushed the USD trade-weighted exchange rate to near two-decade highs;
- Sharp depreciation of regional currencies, especially the Japanese yen. This has pushed up the renminbi’s trade-weighted exchange rate (CFETS) significantly, prompting the People’s Bank of China (PBoC) to shift to a weak RMB-USD cross-rate policy to halt further CFETS appreciation (see below for more information).
What is driving portfolio outflows?
- The interest rate differential between Chinese and US government bond yields has shrunk to almost zero due to the divergence between monetary policy in China and the US;
- Market pessimism over the outlook for China’s growth and asset markets. Investors are concerned about the country’s zero-Covid policy and perceive insufficient policy support to stabilise economic growth;
- Regulatory risk as the US forces Chinese stocks to delist from US exchanges. This has led to a sell-off of Chinese stocks not only in the US, but also in Hong Kong and on the China A-share market.
Has China shifted to a devaluation policy?
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 else being equal. Under normal market conditions, when the CEFTS is rising, the PBoC will guide RMB-USD lower to offset some of the upward pressure on the CFETS basket, and vice-versa.
However, contrary to the market’s perception, China is not just targeting a stable RMB-USD cross-rate. It only prioritises stabilising 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, especially the Japanese yen, against the strong US dollar has pushed up the CFETS sharply since late 2021 (see Exhibit 2). The Chinese authorities are uncomfortable with this. As the dollar has gone from strength to strength recently, the PBoC has tolerated more RMB-USD weakness to lessen the appreciation pressure on the CFETS; RMB-USD weakness is not a devaluation move.
The PBoC wants the renminbi to display two-way fluctuations around its ‘fixing’ as part of the bank’s foreign exchange reforms. It will intervene in the market to stamp out any one-way speculation.
What are the PBoC’s intervention tools?
Capital controls are the last resort. The other common tools include, but are not limited to:
- Direct intervention (by buying and selling foreign exchange in the market) and verbal intervention (including giving policy directives to banks on currency trading);
- Changing the reserve requirement for foreign currency deposits at banks, thus adjusting the supply of foreign currencies to the market. For example, in late April, the PBoC cut the banks’ foreign exchange reserve requirement by 1% to 8% (increasing the supply of US dollars by 10 billion) in an attempt to slow the pace of the RMB-USD depreciation;
- Using the Countercyclical Factor in changing the daily fixing;
- Changing the limits of domestic banks’ offshore lending to influence the renminbi supply;
- Increasing the cost of short-selling renminbi onshore by raising the risk reserve requirement for banks’ forward foreign exchange positions.
Will the renminbi fall further?
It is likely to, as near-term depreciation pressure on the renminbi will probably remain strong, namely:
- Hedging by Chinese companies against expected further renminbi weakness;
- Continued policy divergence between China and the US;
- Uncertainty about US regulatory risk on delisting Chinese stocks, leading to portfolio outflows;
- Poor market sentiment with no end in sight for the zero-Covid policy;
- Greater tolerance by the PBoC for a weaker RMB-USD rate to arrest the upward pressure on the CFETS exchange rate;
- Negative sentiment on world growth (crimping Chinese export growth) thanks to aggressive policy tightening by the main central banks and the continuing Russia-Ukraine crisis
Basic balance supports
Given that the CFETS exchange rate has risen notably, and assuming other currencies in the basket do not move by much, the PBoC will likely allow the RMB-USD cross rate fall to 7 per USD in the near term to drive CFETS down towards 100 from the current 103-104 level.
Beyond the near term, however, fundamental support for the renminbi from China’s basic balance is still solid. The country’s current account balance is in surplus and China still benefits from net foreign direct investment (FDI) inflows.
Once market and investor sentiment on China improves, net portfolio inflows should return. Given the existing fundamental support, these factors should allow the renminbi to recover next year.