China’s currency is anchored by the dollar, against which it cannot move by more than 2% per day, a regime that has been in place since March 2014, when it was raised from 1%.
The dollar’s recent ascent has therefore pulled RMB away from other currencies, leaving it increasingly overvalued: while RMB saw a 2.6% nominal depreciation against the dollar in 2014, it appreciated by 6% against a trade-weighted basket in the same year.
Indeed, according to the Barclays behavioural equilibrium exchange rate model, the renminbi remains the second-most overvalued currency in the world, behind the Philippine peso but ahead of CHF and NZD.
There is considerable downward pressure being exerted on the currency.
Dennis Tan, FX strategist at Barclays, says: “There were clear signs of resident outflows accelerating last year. Onshore FX deposits surged in 2014, largely due to corporates holding more of their export proceeds in foreign currencies.
“Similarly, outflows recorded under the currency-and-deposits component of the balance of payments also picked up.”
Non-FDI outflow reached an estimated $160 billion in Q4 2014 alone. China has also seen hot money and carry-seeking inflows – such as borrowing cheap dollars via illicit channels to lend onshore – slow down or unwind.
And the government has also cracked down on efforts to circumvent credit controls such as fake exports and over-invoicing, off-balance sheet lending in the interbank loans market and the monitoring of collateral. These abuses have traditionally tended to strengthen RMB.
The market therefore expects 2015 to bring further falls for RMB. Forwards are pricing in a 3.4% depreciation in CNY versus USD over the next 12 months, and banks broadly agree. Barclays forecasts USD/CNY will be around 6.40 by end-2015, while UBS has called it at 6.35 by year-end. HSBC forecasts 6.34 by year-end 2015 and 6.44 by year-end 2016.
However, such a move will be impossible without the government’s blessing, and the big question is how Chinese authorities covet a weaker renminbi.
Paul Mackel, head of Asian FX research at HSBC, believes China is unlikely to follow a strategy of weakening its currency, which “would go against the authorities’ commitment to economic rebalancing and structural reforms. The former, expressed simply, is aimed at reducing the previous over-reliance on exports and investment,” while a stronger currency helps boosts domestic purchasing power for imports and, thereby, boosts consumption.
Mackel believes “the People’s Bank of China (PBoC) is more committed to basically exiting routine spot FX intervention and liberalizing the exchange rate regime”, even if it means exchange-rate appreciation.
Interestingly, China understands its relative clout in global trade means FX weakening would be disruptive to trade flows and international relations, says Mackel, even as analysts argue any weakening would be driven by market fundamentals.
China is also concerned that too much weakening will undermine its efforts to promote the internationalization of RMB, which has been buoyed by the impression nurtured in the market that the currency is a one-way appreciation bet.
And there is some apprehension that too much RMB weakening could encourage greater outflows and volatility, creating a vicious circle of downward pressure.
Despite large and persistent capital outflows, China still has a sizeable and rising current-account surplus of $214 billion, notes Donna Kwok, an economist at UBS. The bank expects this to rise to more than $250 billion in 2015. A trade surplus of more than $500 billion provides a sizeable offset to capital outflows.
“The US government has continued to put pressure for China to appreciate its currency and such pressure does matter,” she says. “In addition, although many may think that a currency war is already upon us, a large depreciation by China would almost certainly intensify competitive devaluations in the region, which, in the end, may not benefit China much.”
However, such considerations have to be set against the cost of defending the currency at its current level. HSBC calculates Chinese FX reserves fell for the final two quarters of 2014, with modest interventions of $7 billion of selling in Q3 and $5 billion of buying in Q4, down from interventions of more than $100 billion in late 2013 and early 2014.
Selling USD to defend the USD/RMB band would also have the adverse impact of tightening domestic CNY liquidity unless sterilization measures were taken to neutralize the liquidity impact, says Barclays’ Tan.
“A further drain of liquidity may not be ideal if the growing risk of deflation forced China to step up monetary stimulus,” he says. “If FX intervention were to continue, the tightening effect on domestic liquidity would also make monetary stimulus less effective.”
HSBC’s Mackel adds: “We believe a 2% to 3% spot RMB depreciation against the USD is acceptable to Chinese policymakers in the face of a strong USD trend and will not derail the RMB’s internationalization goal.” Along the way, RMB will see greater two-way volatility than it has in the past, he says.
|The future of the RMB:|
One option available to China is to relax the USD/RMB trading band. That might prove a politically feasible way of weakening the currency because it can be presented as a liberalizing measure, mitigating any negative political or market reaction. Changing the fixing rate, by contrast, might be more likely viewed as an attempt to manipulate the currency to China’s advantage.
However, there will still be a problem in the timing.
“China may refrain from widening the policy band when market pressure on the CNY is most heavy,” says Tan. Instead, it will be patient and wait for an opportune moment.
HSBC agrees 2015 looks set to see an acceleration of reforms, with both a widening of the trade band and a clean-up of the fixing mechanism to make it more transparent, on the table.
However, Kwok at UBS does not see a widening of the band as likely.
“It is neither needed nor tactically desirable right now,” she says. “If the government wanted to allow for a greater degree of depreciation, it can easily achieve this by moving the fixing higher more frequently and to a greater degree.
“Widening the trading band now would only further aggravate depreciation expectations, counter to what we believe is the PBoC’s goal of maintaining a largely stable currency.”