Second ‘Yuaniversary’: An Analysis on the Recent RMB Rally

1. Retrospect of 8·11 FX Reform

• Roller Coaster Move for CNY Exchange Rate

The first round lasted two weeks with USD/CNY fixing rate depreciated by 4.6%, of which 1.9% of depreciation occurred on the first day (Aug 11, 2015). Though PBOC stated that such adjustment was a ‘one-off’ devaluation, and that RMB had no foundation for further depreciation, market didn’t believe and continued short selling Chinese Yuan. PBOC had no choice but reentered the market to stabilize exchange rate.

The second round started from Nov 2015 to mid of January, 2016, during when RMB declined 3.8% against USD, which strengthened dramatically after first rate increase. Besides, PBOC changed its ‘dollar-pegged’ mechanism by pegging with a basket of currencies, under which CNY had two pegs actually: USD and a basket of currencies. If USD index strengthens, RMB can peg with a basket of currencies to keep its value stable against the currency basket, and vice versa. However, such dual-pegged system was believed to be a speculative tactic for gradual devaluation. This triggered further weakening of CNY.

The third round began from May to mid of July, 2016. The Brexit worsened market turbulence and depressed Yuan’s fixing rate towards 6.7.

In the final round, the Trump effect and second rate hike were catalyst for RMB depreciation. RMB fixing rate slid further to 7.0. 

All the above depreciation trends were triggered by factors from home and abroad, but only home factors could be well controlled. Based on the performance history, we believe that PBOC was adopting a gradual depreciation tactic, in which insufficient devaluating adjustment can hardly release all the depreciation pressure, but was very likely to ignite panic for further weakening and incur tremendous losses of foreign reserves to maintain foreign exchange stability. Furthermore, the aforementioned dual-pegged system seemed unclear and led market to believe the RMB valuation was still far from its balancing level, thus triggering large volatility of exchange rate.    

Surprisingly, USD/CNY stabilized and rallied 4.5% as of Aug 28, thwarting the big short. Net errors and omissions, a key indicator of capital flight, shrank 35% y-o-y in 1H2017. In the meantime, China’s foreign reserves expanded for six straight months by USD82.5 bn. Why?   

• What Triggered Exchange Rate Rally?

First and foremost is the weakening USD effect. Trump effect gradually faded away amid Trumpcare demise and Russia probe. By contrast, EU and Japan saw healthy economic recovery, and a tendency of possible tapering in their monetary programs. Plus, no ‘black swan’ in Europe recently. Euro and Japanese yen were accordingly strengthening. Since the inception of 2017, CNY appreciated 4.5% against USD, but depreciated 1.9% and 7.9% against JPY and Euro, respectively. 

Looking into home factors, we’d highlight capital control first. Chinese State Administration of Foreign Exchange (SAFE) imposed strict regulation on capital outflow, especially on cross-border lending, namely ‘onshore guarantee for offshore loans (内保外贷) ’. Authorities also warned risks of overseas investment in real estate, culture, sports and entertainment industries. As such, non-financial outward investment saw a big slump in year-to-date growth, from 40% last December to -44% this July. Total outward investment was amounted to USD57.2 bn year-to-date, only accounting for 1/3 of last year. Outward investment in real estate, culture, sports and entertainment tumbled over 80% y-o-y.  

Huge decline in outward investment alleviated the problem of capital flight. Position for foreign exchange purchase only shrank marginally by RMB432 bn from January to July in 2017, less than 10% of decline in 2016.  

Secondly, the newly added countercyclical factor in May propped up RMB exchange rate. Previously, PBOC set RMB fixing rate based on prior day’s closing price and a basket of currencies.  But the procyclical effect may amplify market volatility and worsen depreciation pressure. 

With the countercyclical factor, fundamental indicators can be taken into account to hedge the herding effect of depreciation. For instance, suppose fixing rate of USD/CNY is set at 6.7 in Day 1. If closing price of CNY in Day 1 depreciates, or USD index picks up, the market force could depress CNY’s exchange rate in Day 2. However, if PBOC believes that China has better fundamentals than US, it can reverse the course by keeping USD/CNY fixing rate unchanged. The chart above shows that RMB exchange rate rebounded after introduction of countercyclical factor, as improved outlook of Chinese macro economy was taken into consideration.

The third reason for recent rally is about financial deleverage. Preventing asset bubble and systematic financial risk was frequently mentioned in PBOC’s report this year. Monetary policy became neutral, lifting market rates marginally (For detailed research on financial deleverage, please refer to: Link). Besides, economy in 1H2017 was slightly better than market consensus, thus improving confidence in CNY and slowing capital outflow. 

2. Side Effect: RMB Globalization Comes to a Standstill

The year-to-date rally of CNY against USD reflects that exchange rate stability has been largely realized. But given the visible hand (e.g. regulated interventions, especially newly introduced ‘countercyclical factor’) in RMB’s central parity mechanism, we regret to say RMB is moving to the opposite of free-floating exchange rate target, which in turn slows RMB globalization. Chinese Yuan’s functions for international payments, investment, and foreign reserves are impaired.  

Prior to 8·11 FX reform, RMB share in global payments was picking up rapidly, reaching 2.79% in Aug 2015. Upon the second anniversary of FX reform, nevertheless, the share declined drastically to 1.98% as of Jun 2017. 

In addition, foreign investors have less interest in bonds, loans, and deposits denominated in CNY after 8·11 FX reform. As of Jun 2017, more RMB equities (2.1%) and bonds (1.9%) were held by foreigners than loans and deposits, but the absolute share level was extremely low.  

Last but not the least, current RMB reserves account for merely 1% of global allocated reserves, far below 10.92% of SDR basket weights at IMF. Such difference indicates huge deviation between real reserve value and nominal SDR value. 

3. Exchange Rate Outlook

Even though RMB globalization is subordinate to exchange rate stability, at this very timing, it should be a well-thought-out balance of government tactics. We must also be careful that recent RMB rally might be a valuation rebound rather than a course reverse. Given uncertainties from home and abroad, market participants should keep vigilant to potential exchange rate volatility in the near future.

First of all, Chinese economy would face strong headwind as domestic property market began to enter correction cycle. If GDP growth slows again, the neutral stance of monetary policy has to be more accommodative and eventually hurts stability of RMB valuation. Additionally, the year-to-date balance of foreign exchange settlement and sales is still in deficit, meaning no fundamental reverse for net capital outflow. Thus, we still have to watch out depreciation risk. 

Looking abroad, we have to mind two things.

Firstly, Fed has recently agreed to begin implementing balance sheet normalization relatively soon, which would be a strong tailwind for USD. Further, trade conflict or even small-scale trade war between US and China is still likely to happen, as US recently started investigation into China's intellectual property practices. These factors could also heighten volatility of RMB exchange rate.

In summary, fasten your belt to withstand uncertainties ahead. 

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