China's balancing act on exchange rate

Solomon Teague
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China's quarter-point rate cut last Friday is the latest attempt to revive a flagging economy. But although currency liberalization is on the agenda in the longer term, the People's Bank of China is unlikely to be ready to cede control of the renminbi’s de facto dollar peg just yet as depreciation pressures grow.

Ten years after China scrapped the renminbi’s formal peg to the dollar, it’s no secret that the central bank’s continued, albeit more implicit, anchoring of the exchange rate to the greenback remains key to policymakers’ growth calculations. Accordingly, the conflict between China’s near-term bid to add juice to its economy, amid deflationary pressures, which implies a weaker but fairly stable currency, and its medium-term ambition to rebalance its economy with a more flexible FX regime has taken centre stage.

China’s August renminbi devaluation and changes to the way it calculates its daily FX appeared to have dodged this trade-off by boosting the competitiveness of exports while the latter, in theory, makes the value of the exchange rate more sensitive to market-implied fundamentals.

What’s more, signs that the IMF will include the renminbi in the SDR currency basket irrespective of whether or not Beijing further liberalizes its FX regime also gives China breathing room to continue the status quo of gradually reforming the exchange rate regime.

But given elevated risks of deflationary pressure, and expectations of a rising dollar amid a tighter Federal Reserve policy, some market analysts reckon the People's Bank of China (PBoC) should explicitly remove the dollar peg, although most reckon a policy of reform gradualism is to be expected.

In sum, downward pressure on the renminbi is growing, raising questions about the sustainability of the exchange-rate regime, in general.

On Friday, October 23, after the market had closed, the PBoC reduced the benchmark interest rate by 25 basis points, with the one-year lending rate falling to 4.35% and the one-year deposit rate to 1.5%. The reserve requirement ratio (RRR) for commercial banks was also cut by 50bp to 17.5%, with larger cuts for selected banks.

The renminbi has not participated in the rally in Asian currencies in October, and is the worst-performing currency in the region for the month to date.

Andy Wu, senior economist at MNI Indicators, says: “The anticipated interest rate differential between the two countries has been narrowing. This inevitably leads to additional capital flight. Undoubtedly, the risk of a downward spiral in the value of the yuan will continue to grow.”

This trend could become self perpetuating as it undermines sentiment, he notes, with capital outflows likely to lead to greater devaluations of China's currency.

Renminbi, China, Graph
Observers doubt the rate cut is going to be a game changer in this respect. Khoon Goh, senior FX strategist at ANZ, says: “While some in the market sees an interest rate cut by the PBoC as positive for risk, the offshore CNH spot weakened after the rate cut was announced. CNH was trading at 6.3884 against the USD when the news came out, and closed at 6.3964 for a loss of 0.13%.”

CNH has historically weakened by an average of 0.1% in the immediate aftermath of a rate cut, he notes.

Goh says: “The release of financial institutions' net FX purchase data and banks’ FX purchases and sales on behalf of clients data indicate that there were large outflows in September. After adjusting the net FX purchase data for the trade balance and net FDI flows, our proxy estimate for capital outflows in September was $179 billion, a record amount and slightly larger than the $169 billion outflow estimated in August.”

Although outflow pressures appear to have eased in October, “genuine demand for dollars remains,” says Goh. “The widening of the spread between CNY and CNH to over 460 pips last Friday is another indication of this. With last Friday’s rate cut, outflow pressures could pick up, and renewed depreciation pressure emerge.”

Yet this will not be enough to force the PBoC to release the reins on its exchange rate, says Wu. “We believe China will continue to weaken its dollar peg at a gradual pace,” he says. But “if China wants to keep the yuan relatively stable, the PBOC must manage it more proactively.”

Nicholas Ebisch, analyst at Caxton FX, is even more cautious. “China has made clear that weakening the dollar peg is an option they will consider in the future, but it has a much larger and more destabilizing effect than cutting interest rates or cutting the reserve requirement as they have many times throughout the last year.”

He therefore expects China to bide its time. “It is unlikely that China will weaken its dollar peg as it did earlier this year in August, as that had a drastic effect on the global economy and sparked worldwide concern that the Chinese economy was slowing down rapidly,” he says.

Such a move would also fan the flames of volatility, given the difficulty the international markets would have determining the value of the renminbi, he adds.

Renminbi, China, Graph
Ebisch says: “For a currency to be de-pegged from the dollar, there needs to be some of the currency available to trade on the open market. The CNY is a protected currency, which is very difficult to obtain on the open market. Therefore, if more of the Chinese currency becomes available and the currency peg is removed, then investors would be able to judge for themselves and an equilibrium value would be established between the CNY and other currencies.”

But when it happens, a floating renminbi will eventually stabilize the Chinese economy, predicts Ebisch. It might encourage greater investment by giving investors confidence they will be able to recoup their losses if they have a renminbi-denominated investment in the country, he says.

Such a move is inevitable in the longer term, and some market participants have expressed frustration at the pace of reform in China. “We have been disappointed by the pace of economic reform in China recently, and also by the government’s ineffective attempts to manage the liberalization of both the renminbi and the stock market,” says Gary Greenberg, head of emerging markets at Hermes Investment Management.

It remains a question of control, says Wu. “The Chinese authorities are currently not keen to remove the peg completely or accelerate the pace of exchange rate reforms more significantly because of a loss of control over one of the key elements of the economy,” he says.

A big concern for the PBoC might be that once it acts it will be difficult to reverse the decision. It will therefore be determined to get the timing right, acting at a time when it is confident it will not need to step in to stabilize the ensuing volatility.

Ebisch says: “Once restrictions are taken off, putting them back on will become harder and harder as time goes on. Reinstituting restrictions would mean that governments that had been stockpiling renminbi would lose faith in the currency and sell it for more stable international currencies. Once Pandora’s Box of currency liberalization has been opened, it is near-impossible to close again.”

However, even a managed decline of the currency will be hazardous for China. “If the yuan continues to drop more noticeably, concerns over capital outflows will likely intensify, which could potentially lead to serious financial instability and major economic fluctuations,” says Wu.

Greenberg adds: “The conflict between the incompatible goals of party control and a market economy has come to a head sooner than most observers imagined.” But he is confident the drive to reform will continue. He says: “After the recent false starts and mis-steps, China will resume the process of reforming state-owned enterprises and slowly continue to progress towards a market-based consumer economy.” A freely floating renminbi is an intrinsic part of that vision.

In the meantime, most observers expect incremental weakening of the currency. SG notes that, on a trade-weighted basis, the Chinese currency is well above its long-term average, and is one of the most expensive among emerging markets, when comparing current levels with the respective five-year averages.

“We believe that the PBoC will allow gradual depreciation of the renminbi towards its fair value,” says SG. “We like being long the CAD/CNH as this a good hedge against China policy surprises in a context of a bottoming out of oil prices. Our target is the 5.800 level, seen before the start of commodity complex rout.”

Whether or not China devalues the nominal renminbi, the renminbi real exchange rate must fall, involving some combination of lower asset and lower high street prices, CrossBorder Capital says in a note to investors.

Both already appear to be happening. But the falling prices option is likely to be more damaging to the Chinese economy, says CrossBorder, either through negative wealth effects or reduced income growth. “The only respite for policymakers is to channel the real exchange rate adjustment through a weaker nominal renminbi, something which we anyway believe is inevitable given the scale of US dollar outflows.”

However, Greenberg, at least, does not see further weakening as a foregone conclusion. “Further weakening of the renminbi cannot be entirely ruled out, but China’s current account remains positive at the current exchange rate, so it is unclear what a lower currency would accomplish. In fact, on a trade-weighted basis, the renminbi is not meaningfully overvalued,” he says.