The rise and rise of the renminbi used to be considered a foregone conclusion.
It was accepted that the Chinese currency (referred to as both RMB and CNY in foreign exchange parlance) would be worth a whole lot more were it not artificially pegged to the US dollar, or otherwise restricted in its movements. This assumption has been the basis of years of objection from the US about unfairly subsidised Chinese exports.
To judge by market movements since China tweaked the renminbi’s peg to the US dollar in June 2003 to allow modest gains, the currency definitely was undervalued. Since then it has settled into a steady pattern of about 5% appreciation a year against the US dollar – despite a two-year period from 2008-10 when it was frozen. Until recently the currency was widely expected to continue appreciating in the same way.
Expectations of such continued appreciation are one of the key reasons that Hong Kong’s offshore renminbi, or ‘dim sum’, bond market has taken off so abruptly over the past 18 months. Buyers have factored in a near-guaranteed currency appreciation on top of whatever yield the bonds pay.
But something has changed. Market expectations that the renminbi will keep rising against the dollar have become less certain, with most foreign exchange analysts in the region having recently reduced their outlook for RMB appreciation.
Nomura’s Simon Flint has a base case of a less than 3% rise in 2012; HSBC’s Paul Mackel, head of Asia currency research, predicts around 3%, but with the potential for much worse and with heightened volatility. Chua Hak Bin, head of emerging Asia economics at Bank of America-Merrill Lynch, says he is “looking for a much weaker pace of appreciation for the RMB”; while Citi’s Nadir Mahmud estimates 2%-3%; and Deutsche Bank’s Linan Liu is looking at about 3.5% (in its offshore form at least).
Even the most strident renminbi supporters predict a slowing of its appreciation. Shankar Hari, head of foreign exchange for Asia ex-Japan at J.P. Morgan, notes that the RMB “has maintained its fundamental strength through all the financial stresses of the last 12 months”. He adds: “There will definitely be more volatility this year, but there is no structural change and the eventual trend will remain quite constant.”
But he, too, expects a slowing of growth; his year-end call, for an exchange rate of 6.05 to the dollar, equates to about 4% appreciation.
There is even a view being considered – albeit an unlikely one – that the renminbi could decline in value against the US dollar.
“The most notable development for the RMB recently has been the almost persistent depreciation pressure the currency has been facing since the end of September,” notes Mackel at HSBC. Reserves have begun to show net outflows. “RMB depreciation is highly unlikely, but not impossible, should the US dollar suddenly be much stronger,” he adds.
Could the renminbi finally be set to fall?
China’s economy
There are several reasons for the slowing of the renminbi’s advance.
It is partly a product of Beijing appearing to have a handle on inflationary pressures, combined with lower economic growth, in part due to the debt problems being experienced by China’s greatest trade partner, Europe.
This has led to concerns of a domestic hard landing (which in China means GDP growth of under 6%), which is also influencing the government to cushion the currency’s rise. These concerns are particularly acute this year, given that the critically important 18th Party Congress is likely to take place in October, during which the country’s top leadership is replaced.
Taking a view on the renminbi’s future strength depends largely on whether the country’s economic growth declines a lot or a little – commonly known as a soft or hard economic landing.
The more commonly held view at the moment is that China’s GDP growth will slip, but only to levels that would still look remarkable everywhere else in the world. The country’s annual economic expansion rate dropped from 9.1% in the third quarter of 2011 to 8.9% in the fourth, bringing its full-year growth to a still-robust 9.2%.
J.P. Morgan anticipates that GDP growth will slide further to 7.6% year-on-year in the first quarter of 2012. That’s a notable decline, but it still means China’s economy is expanding faster than almost anywhere else in the world – even Indonesia, the darling of emerging-market investment flows today.
“Our view is it’s going to be quite a soft landing,” says Adam Gilmour, Asia Pacific head of derivative and FX sales at Citi. “The budget deficit in 2011 was 1% of GDP. If you compare that to all of the western world – to pretty much everybody – it’s next to nothing. China’s a massive economy now, it has firepower, and if it wants to do something about it, it can. The probability of a hard landing is almost zero.”
Dollar demand
If this moderating growth is the case, then it is much more likely that the currency’s value will moderate rather than decline.
However, a strengthening US dollar would have a big impact on the renminbi’s valuation too. The dollar is enjoying a somewhat unlikely renaissance at the moment, as some reasonably bright economic numbers have been accompanied by enthusiastic flows into the US dollar as a low-risk currency.
The exchange rate is not just about economic data and fund flows. Flint is also keeping an eye on what he sees as worsening Sino-US political and economic relations. He expects an acceleration of World Trade Organisation cases against China, and believes hostile renminbi-related legislation could pass through the US Congress, probably without president Barack Obama wielding his veto to prevent it. That could have a sizeable impact on the renminbi’s outlook, particularly for China’s policymakers.
“Although the direct substantive impact of such a bill is likely to be small, its symbolic importance would be significant,” he says. “China will not wish to be perceived as accelerating CNY appreciation under duress.”
Other political issues that could conceivably also have an impact on the currency include relations with Taiwan and an expected visit by Chinese vice-president Xi Jinping to the US early this year.
Yet while all these factors have muddied the picture for RMB forecasts, very few experts think a decline against the dollar is realistic in the short term.
“Depreciation is unlikely, in our opinion,” says Flint. “We believe that China will be wary of a number of risks which would militate against depreciation: domestic capital flight; being perceived as exporting their domestic economic strife; undermining efforts to internationalise the CNY, and being seen as provocative towards the US.”
Fair value
But if a drop is unlikely, is it possible the RMB represents fair value now?
Mackel at HSBC thinks that the RMB is “close to an equilibrium valuation”. And, logically, if a currency’s value against another is at less than the maximum that a foreign-exchange ceiling permits, it can be argued that it is no longer artificially being kept undervalued.
But some think this is the wrong question.
“I’m always surprised people talk about where the fair value of the RMB is,” says Ulrich Leuchtmann, managing director and head of FX research at Commerzbank. “People say the RMB should be there or there, and then the Chinese trade balance would be at some normal or long-term sustainable level. I don’t know how they get it.”
Leuchtmann argues that Chinese economics around the exchange rate simply don’t work as they do in the rest of the world.
“We saw rising trade surpluses in times of RMB appreciation, we saw falling trade surpluses in times of RMB depreciation. The usual pattern simply does not apply.” And since the Chinese trade balance is apparently not sensitive to exchange rates, it makes it difficult to think in terms of fair value.
Instead, Leuchtmann believes that it’s wiser to focus on the impact of China’s ongoing efforts to cap the rise of its currency to a certain level versus the US dollar.
The country’s FX regime, loosely defined, involves two stages: a daily mid-point fixing, around which the currency can trade; and large-scale foreign-currency reserve accumulation, courtesy of the People’s Bank of China (PBoC) sterilising US dollar inflows into China by buying the currency at a fixed rate. This means that the central bank acts as the main determinant of FX supply and demand.
Sterilising FX inflows has been a major undertaking, given major foreign investment inflows and overseas profits from Chinese companies. As a result, China’s foreign currency reserves have burgeoned to around US$3.2 trillion. The central bank has essentially printed money to pay for its sterilisation actions, but doing so has limited the nation’s ability to respond to other problems, such as inflation.
“The Chinese themselves are having more and more problems with the current exchange-rate regime than the US does,” says Leuchtmann. “It means the Chinese have less ability to control inflation. A lot of the measures a central bank usually could apply to control inflation, at the moment are needed to sterilise what they are doing in the FX market.”
What this means is that China may have little choice but to shift to a more flexible exchange-rate regime faster than many observers may think. “Others think five or 10 years. I think something like two years. It’s in their interests to change this regime, though only gradually,” says Leuchtmann.
Others agree. In January HSBC put out a report entitled: “FX regime under siege?” In a nutshell, this argued that China’s exchange-rate regime was set up to handle persistent inflows, and was ill-suited to handle more volatile net flows of the type that have evolved since September.
Given the rising challenge of combating inflation generated in part by its own FX intervention policies, China evidently needs to evolve its FX regime. But how?
In the near term, HSBC says, the PBoC could deploy FX reserves, selling US dollars to counteract demand for the currency and bring the spot price back in line with long-term patterns. Alternatively it could allow the market to establish its own equilibrium; it could widen the RMB/USD trading band; or it could continue to set the daily fix as usual and ignore what the spot market is doing.
“It is not yet clear how this situation will ultimately play out,” noted HSBC, noting that a combination of the first and last options was most likely. “One likely reason for the policy to have taken so long to respond is that the authorities have not faced such a situation before.”
Offshore impact
Complicating things further is offshore renminbi – known by yet another acronym, CNH. This iteration of the currency behaves rather differently to the onshore version, and if anything it’s becoming more different all the time.
“CNH has completely gone full circle,” says Hari at J.P. Morgan. “CNH-CNY was at a premium [in favour of CNH] to start with; now it’s a discount, with CNH depreciation.”
The shift has been dramatic: CNH stood at a 2.3% premium to CNY in 2010 and a 1.9% discount by September 2011. Hari attributes this to a slowing growth of deposits and a large number of new dim sum bonds, which offered more choice to investors and reduced the imperative for CNH to be at a premium to CNY.
It was a remarkable movement, noted by other analysts too. “Perhaps the most surprising development [in 2011] was the reversal in the CNH-CNY spot basis, and the two-way volatility since,” says Liu at Deutsche Bank.
That might suggest weakness in CNH, but the market grew considerably in 2011, both in dim sum bonds and the expansion of cross-border trade settlement.
“The offshore RMB market achieved impressive development milestones in 2011 in terms of the amount of trade settlement, the size of the offshore liquidity pool, CNH FX trading volume and the size of the fixed income market,” says Liu.
Most expect to see further international development of the renminbi market this year. Several new milestones are anticipated. These include more renminbi-denominated foreign direct investment programmes (one formally launched in November), which let overseas investors put renminbi-denominated money to work directly in China.
In addition, more renminbi cross-border trade settlement is likely, and there should be more trading partners in renminbi cross-currency swap arrangements (particularly with Asean countries) and more trading centres for CNH bonds.
The coming months will also see the launch of the RMB qualified foreign institutional investor funds, which are set up by the offshore divisions of Chinese brokers and asset managers that can invest in local Chinese bonds.
Deutsche expects these developments to encourage a lot more demand for renminbi. It predicts that companies will conduct CNH150 billion-CNH200 billion in CNH bond issuance for RMB foreign direct investment purposes this year; Rmb3.7 trillion of renminbi trade settlement, a 67% year-on-year increase; daily CNH FX trading of US$3.5 billion-US$4 billion, up from about US$2 billion today; an offshore renminbi deposit base of CNH1.5 trillion; and gross issuance of offshore renminbi bonds of CNH280 billion. It also expects CNH bond total returns of 7.4% in dollar terms: 3.9% of it the bonds, 3.5% the currency.
That’s all good for the future of the market, but it also means that spot-price volatility between the two forms of the currency is expected to last at least for the first months of this year.
The differing performance of the two arms of the same currency is not necessarily a bad thing; some are already finding ways to make money from it, and they are not just traders.
“Onshore corporates and MNCs [multinational companies] have become active in taking advantage of the differences in the onshore and offshore exchange rates recently,” says Liu. She says Chinese exporters, and companies with US dollar receipts generally, have started to shift more dollar sales to the CNH market, while making dollar purchases onshore.
Mark Burrough, head of FX product management in treasury services at J.P. Morgan, adds: “Use of the offshore forward market is becoming more prevalent, and growing. It opens opportunities for corporates in that space in terms of what tools they can use for hedging.”
How to hedge
It’s certainly a sign of the times that houses are now advising their FX clients about the renminbi.
Since nobody thinks the renminbi is going to go straight up anymore, and since it will have this odd onshore-offshore difference, FX traders clearly have an opportunity to make a market. Deutsche, for example, expects volatility of the dollar-yuan cross to rise, particularly since premier Wen Jiabao’s announcement in November that China will start to “increase the yuan’s flexibility in both directions”, a message reinforced by the PBoC in December.
Thinking this through, Deutsche argues offshore non-deliverable forwards (NDFs), or a type of derivative used to synthetically anticipate how the renmnbi’s value will change in the future, will be more volatile than onshore spot. It also predicts that further weakness in Chinese economic data will hit the value of NDFs again, and is thus telling clients to go long on CNY volatility while simultaneously taking a short one-year dollar/yuan position through NDFs or CNH.
It’s hard to find a consensus on exactly what will happen to the renminbi’s valuation over the coming months. But strategists tend to have a few things in common: they see continued renminbi appreciation, but at a slower pace and with greater volatility; they expect the offshore renminbi market to continue to grow, with the CNH-CNY spot continuing to move around; and they expect a soft landing for China, with attendant moderate consequences for the currency.
But even the fact that there’s a debate to be had is a major event: the days of the renminbi’s inevitable rise are long gone.