Chi on China Up or Down? The Knowns and Unknowns of the RMB New Normal

Transcription

1 For professional investors 28 January Chi on China Up or Down? The Knowns and Unknowns of the RMB New Normal SUMMARY The knowns: China s renminbi (RMB) has entered a new normal environment characterised by two-way trading and higher volatility since Market players have responded by increasing onshore FX hedging activity, which contributed to last year s drop in the RMB against the US dollar (USD). The unknowns: Will the RMB s weakness continue and fall sharply in 2015, as some analysts forecast? What is the People s Bank of China s (PBoC) exchange rate policy stance? Will it shift to target the RMB s trade-weighted exchange rate, or will it continue to target the RMB-USD cross rate, and why? Against all odds: A policy shift towards targeting a stable trade-weighted exchange rate would prompt the PBoC to devalue the RMB against the USD. But our research shows that it would likely continue to ignore the trade-weighted exchange rate and target a strong RMB-USD cross rate for good reasons. Since the PBoC squashed the one-way bet on RMB appreciation in early 2014, it has intervened less in the FX market 1 (Charts 1 and 2), allowing the currency to enter a new normal paradigm in which two-way trading and FX volatility have finally become a reality. Market players have responded by increasing onshore FX hedging activity, which helped weaken the RMB against the USD in late However, economic fundamentals remain supportive of a mild RMB-USD appreciation in the medium-term 2. 1 In fact, the PBoC has been loosening its grip on the RMB, albeit very slowly, amid its appreciation trend since 2006 (Chart 1), suggesting a gradual policy shift towards a freer RMB regime. 2 See Chi on China: Fallacies Behind the RMB Predictions, 9 December 2014.

2 The knowns and uknowns of the RMB new normal 28 January Temporary negative flows The RMB weakness in late 2014 that contributed to its 2.5% decline against the USD for the year was due to temporary factors, which should not affect the RMB s medium-term appreciation trend. First, Chinese oil importers increased their purchases, and hence, their demand for USD to pay for the imports, as the decline in oil prices picked up steam in Q4. Monthly crude oil imports totalled more than USD16 billion in the quarter, which was 90% of the USD18 billion daily onshore RMB-USD spot trading volume. More crucially, onshore FX hedging activity rose sharply in late 2014, owing to RMB depreciation concerns in the context of the new normal era. The Bank for International Settlements (BIS) estimated that the USD liability of onshore Chinese companies totalled USD1.1 trillion 3. There is no official data for the amount of onshore hedging activity. But if hedging amounted to only 1% of this liability, it would equal USD11 billion, or 3 Market estimates for total Chinese corporate USD debt average USD907 billion, not far off from the BIS estimate.

3 The knowns and uknowns of the RMB new normal 28 January more than 36% of daily onshore USD spot and forwards trading volume (about USD30 billion). This could easily weaken the RMB, especially should the activity be concentrated. If the PBoC was to target the trade-weighted exchange rate Some analysts have jumped to the conclusion that the RMB would drop sharply in 2015, a view that we have refuted 4. The market s forecast for the RMB exchange rate has focused predominately on the RMB-USD cross rate, ignoring the Chinese currency s trade-weighted exchange rates (or nominal effective exchange rate, NEER, and real effective exchange rate, REER 5 ). The PBoC s FX policy stance towards the tradeweighted exchange rates affects the RMB-USD cross rate directly. According to the BIS s estimates, the USD, the euro and the Japanese yen have the biggest weights (21%, 18.4% and 16.8%, respectively) in the RMB currency basket (Table 1). Our estimates differ from the BIS s in that the USD has a bigger weight (40.3%) while the euro and yen have smaller weights (16.0% and 12.3%, respectively), as we have included the weights of the Hong Kong and Taiwan dollars with the USD s. The reason for doing this is because Hong Kong serves as China s entrepot and the Hong Kong dollar is linked to the USD; this argument generally applies to the Taiwan dollar too. Table 1: Estimated RMB basket (selective currencies) BIS weights Our weights USD Euro JPY KRW SGD RUB AUD GBP MYR INR CAD BRL IDR THB PHP TWD 6.6 NA source: Chi Lo, "The Renminbi Rises", pp.34, Palgrave 2013 If the PBoC targets a stable trade-weighted exchange rate, weakness in the two heavy weights against the USD implies that it would have to devalue the RMB against the USD. For example, using these currency weights, if the euro and yen each depreciates against the USD by 10%, the RMB-USD rate would have to be devalued by 3%-4% to keep the same average exchange rate, ceteris paribus. However, all other things are 4 See footnote 2. 5 NEER is a trade-weighted exchange rate of China s major trading partners, while REER is NEER adjusted for the inflation differential between China and its trading partners

4 The knowns and uknowns of the RMB new normal 28 January not equal, as the other currencies have also fallen against the USD. So the PBoC would have to devalue the RMB by more than 3%-4% against the USD to keep its trade-weighted exchange rate from rising. But it does not The PBoC has never disclosed its FX policy stance, so how do we know which exchange rate it targets? An analysis of the sources of the change in the RMB REER shows that the PBoC is not at all focusing on the trade weighted-exchange rate, which in turn suggests it is still targeting the RMB-USD cross rate. A change in the RMB REER comes from two sources and their interaction: the RMB NEER and inflation differentials between China and its trading partners. Until recently, the PBoC has been intervening heavily in the FX market to slow the RMB s appreciation against the USD. As a result, China s FX reserves have mushroomed 70-fold between 1994 and 2014 to almost USD4 trillion. For the PBoC to buy a large amount of foreign exchange, it has to print RMB, increasing its supply and thus arresting its appreciation pressure. The liquidity spillover of such FX intervention should create inflation, pushing up the REER. And indeed, the RMB REER has risen by more than 50% since the mid-1990s. A large inflation differential between China and its trading partners should explain the REER s sharp appreciation. However, this is not the case. To see why, we broke down the appreciation of the RMB REER between 2005 and 2014 into the relative contributions from the NEER and China s trade-weighted average CPI differential, and compared them with the corresponding statistics from its major emerging markets (EM) trading partners (Table 2). Within the decade, the RMB REER rose by 32.4%, second only to Brazil s 42.7%, while the REER of most of its EM trading partners dropped. Instead of devaluing the REER to gain competitiveness, China simply endured the RMB s strength, suggesting that it was not targeting the REER. The RMB has indeed become the dearest currency in REER terms among its major Asian peers since 2010 (Charts 3 and 4). Further, more than 86% of the RMB s REER appreciation was due to a rise in the NEER (Table 2), which has increased the most among its EM trading partners since Relative inflation has played a minor role in the RMB s REER appreciation, as China s trade-weighted inflation differential is significantly smaller than those of its EM trading partners, except that of South Korea (Table 2). So the PBoC was not targeting the NEER either. Table 2: Contribution to RMB REER appreciation ( H) China India Indonesia Korea Mexico Brazil Turkey Change in REER (%) % due to NEER % due to CPI differential sources: BIS, BNPP IP (asia)

5 The knowns and uknowns of the RMB new normal 28 January

6 The knowns and uknowns of the RMB new normal 28 January No intention to devalue This evidence, in turn, suggests that the PBoC is still targeting the RMB-USD cross rate. Crucially, the persistent strength of the RMB-USD fixing (which is set by the PBoC), on the back of a soft RMB in Q that saw the spot rate trading lower, strongly argues that the authorities were not engineering RMB weakness (Chart 5). A strong currency is the easiest way for Beijing to force economic restructuring in the face of reform resistance. In our view, this is the strongest reason for the PBoC to continue to let fundamental factors drive a mild appreciation of the RMB. Other reasons include the risk of capital flight if market expectations are built into RMB devaluation, and a significant global political backlash against such a policy. The RMB exchange rate is not overvalued 6, so there is no technical reason to expect it to fall sharply. It has played a minor role in affecting Chinese export growth 7, which is predominately a function of global demand, and the contribution of China s net exports to GDP growth has been negative since All this argues that exchange rate plays only an auxiliary role in helping China s GDP growth, and the significant costs involved in devaluing it far outweighs the benefits 9. In a nutshell, RMB devaluation is not China s best policy option. The currency s mild appreciation trend should remain intact in the medium-term 10, albeit with higher volatility in the new normal era. Onshore hedging activity will continue to rise as the PBoC further relaxes control on the currency. The authorities are still targeting the RMB-USD cross rate, using mild RMB appreciation as a tool to force economic restructuring. They have other policy tools to boost GDP growth if they want to 11, but devaluation is not one of them. Chi Lo Senior Economist, BNPP IP 6 See Chi Time: Renminbi Overvalued, Really? 16 July See Chi Time: The Return of RMB Appreciation, 18 June See Chi on China: China s Reform Blueprint: Watch President Xi s Second Term, 2 December See Chi Time: Renminbi Devaluation not China s Best Option, 7 May See Chi on China: RMB Undervaluation, Deja vu, 26 February See Chi Time: China s Growth Slowdown Engineered by Choice, 20 April 2014.

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