The struggle for RMB stability
China’s transition from a highly managed exchange rate regime to a more flexible one has come under much scrutiny, especially in light of the sharp drop in the renminbi. Even though the currency has started to stabilise in recent months, the Federal Reserve is still a wild card. Rev Hui reports.
Talk about moving markets. When the People’s Bank of China announced a new methodology to set its daily USD/CNY fix last August, the market was so unprepared for the change that it caused the renminbi to depreciate nearly 2% — the largest single day fall in the currency. It also started off a chain reaction that spread to equity markets and forced regulators to take extraordinary steps to stabilise China’s financial markets.
It was not meant to be that way. The change was part of China’s commitment to liberalise its currency by introducing a more market-oriented RMB fixing.
Under the new regime, market-makers to the China Foreign Exchange Trade System (CFETS) were asked to take into consideration the previous day's interbank foreign exchange market closing prices, the supply and demand dynamics in the market and global market developments when submitting pre-open quotes. The PBoC would then take those quotes into account when calculating the fix.
Previously, the PBoC had never explicitly told market-makers the basis on which they should make their pre-open submissions each day.
The change had long been called for and was seen as an important step in the maturation of China’s financial system. But what rattled markets was the fact that the PBoC said it expected the new system would lead to weaker fixes. That news coincided with poor exporting and manufacturing data and led to a massive sell-off in Asian equities as markets got spooked that the Chinese economy was in trouble.
The result was a Chinese equity market that ended the year almost 30% down from its peak in June 2015, causing large capital outflows and leaving a lingering question mark over China’s financial strength. The downward pressure on the renminbi also continued, with the currency hitting Rmb6.6 against the US dollar by the end of 2015. In comparison, it was quoted at about Rmb6.2 before the fiasco.
But there have been signs of stability in recent months with the currency hovering around the Rmb6.4-Rmb6.5 area since the middle of March (see chart above).
While China has made no official statement on the currency’s recent equilibrium, the consensus is that the PBoC has been using its vast foreign currency reserves to support the renminbi.
This is borne out by the figures which show the country’s FX reserves have fallen by $800bn since peaking at nearly $4tr in June 2014, according to data from the People’s Bank of China. Approximately $300bn of that loss has been recorded since August. While the reserves increased $8bn in March and a further $10bn in April, outflows are also continuing (see chart below).
David Mann, chief Asia economist for Standard Chartered, agrees that the country’s usage of its FX reserves has been a key reason for the currency’s stability in recent months.
“China could risk triggering capital flight and panic if it allows the renminbi to depreciate now,” he said. “The outflows we experienced last year were mainly caused by depreciation concerns in the first place.”
However, he does not think that dwindling FX reserves will naturally lead to movements in the renminbi as the country still has plenty of other measures to support the currency.
Instead he points out that since the end of last year the PBoC has also been actively using the derivatives market to support the renminbi. This involves getting state banks to borrow in US dollars, which they subsequently sell.
The PBoC then enters into forward contracts with the state banks, which effectively means it will take those trades onto its own balance sheet at a future date. By doing so, the Chinese central bank is able to keep the renminbi up without eating into its FX reserves.
What China wants
For Steve Wang, chief China economist for boutique investment bank Reorient Group, the issue is less about what China can do to keep the currency stable and more about where it wants the currency to be.
"I think China has the tools to keep the renminbi stable for a very long time, so if the renminbi moves, it won’t be because it has ran out of tools but because it wants it to,” he said.
But given the state of the Chinese economy right now, Wang said it is to the country’s benefit to keep the currency stable and not let it weaken. While it is hard to predict just how long China will keep the renminbi trading in a range, things will only change once the authorities deem the economy is in a good-enough state to not require the support.
“It’s obvious that China’s priority right now is to keep its economy stable and for that to happen, the renminbi needs to be stable,” Wang said. “The authorities are probably happy at where the renminbi is right now.”
After all, one of the negative impacts of a weakening currency is that it accelerates capital outflows – something that China has been trying to curb ever since the country came under increased scrutiny over its slowing economy, and with good reason.
China recorded capital outflows of about $676bn last year, according to data from the Institute for International Finance. In 2014, that figure was estimated to be only slightly more than $300bn.
And since the end of last year China has gone to extreme lengths to stop money leaving the country. This includes shutting down many outbound investment channels such as the Renminbi Qualified Domestic Institutional Investor (RQDII) and Qualified Domestic Limited Partnership (QDLP) schemes. Other measures include limiting the supply of US dollars that can be converted at banks and subjecting transfers overseas to greater scrutiny.
Those measures appear to have worked somewhat with capital outflows falling to $60bn in March, half of what was experienced in January.
“It’s not all about curbing outflows because there’s also another side of the equation, which is to improve inflows,” Fitch’s head of Asia Pacific sovereign ratings Andrew Colquhoun said.
Needless to say, China has also been actively trying to do just that with several initiatives such as opening up its interbank bond market to allow most foreign investors to invest directly without the need of quotas. But it is likely to be some time before enough investment flows in to have a meaningful impact.
Bumps along the way
Most market participants Asiamoney spoke with agree with the view that China’s main priority right now is to keep things stable. As a result, it is unlikely to risk inducing volatility back to the markets by juggling with the strength of the renminbi too much for the time being.
Yet while China has shown that it is not afraid to use all the tools at its disposal to keep the currency on an even keel, Yang Xuping, general manager and head of greater China marketing group at the Bank of Tokyo-Mitsubishi UFJ says factors outside of China also have to be taken into account.
"The current stabilisation of the renminbi is against a backdrop of economic recovery in China and the US Federal Reserve’s dovish stance on US monetary policy,” he said. “US monetary policy holds the key to predicting the future of the currency’s market price. If the Fed changes its stance on monetary policy to hawkish, the renminbi may depreciate again."
Speculation is rife as to when the Fed will make its move to hike interest rates.
While market chatter at the start of the year was predicting three hikes of 25bp each in 2016, the Fed has yet to make a single move. Many market participants are now speculating that there could only be one rate hike of 25bp this year.
If and when the US decides to raise interest rates, Fitch’s Colquhoun agrees that a stronger dollar should in theory cause the renminbi to weaken. When that happens, the PBoC’s reaction will be key.
“Do they start using more of their reserves to keep the renminbi at the current levels? Do they allow it to weaken a little? Or do they let it weaken according to the dollar’s gains?” he said. “There are a lot of possibilities.”
In his eyes, the PBoC is likely to allow the renminbi to weaken slightly in response to a US rate hike. He estimates that the currency will fall by about 5% by the end of the year.
But action by the Fed is not the only event that could have an impact on the outlook of the renminbi. Chinese monetary policy could also be at odds with efforts to maintain the exchange rate.
Reorient’s Wang explained that while the US is contemplating increasing interest rates, China, on the other hand, is in the midst of monetary loosening in a bid to boost its economy.
The PBoC has reduced its benchmark one-year lending rate six times to 4.6% since mid-2014. Other similar measures include lowering the reserve requirement ratio (RRR) for banks. The RRR dictates the amount of cash a lender has to keep locked away so reducing it leads to increased liquidity in the economy.
“The more easing measures China undertakes, the more downward pressure there will be on the renminbi,” Wang said. “It’s a dilemma between boosting economic growth using monetary policies and preventing capital outflows by keeping the currency in check.”
Similar to Colquhoun’s views, Wang said the PBoC is likely to adopt a more cautious approach to the currency if and when further easing measures are introduced.
That means allowing the currency to weaken slightly while maintaining a tight control on things by using its vast FX reserves as well as continuing its management of capital outflows.
Yet while most commentators believe the renminbi is likely to remain fairly stable or decline gradually, there are some who think it is bound for the opposite direction.
One such bull is Andy Seaman, chief investment officer for London-based Stratton Street.
And unlike the rest of the street, he expects the renminbi to start appreciating this year. He is also keen to point out that there is no clear linkage between currency strength and a country’s economic growth. “Net foreign asset is the single biggest driver of FX, not GDP growth,” he said. “Countries with a big current-account surplus tend to have a strong currency such as Singapore and Switzerland, so the renminbi should fundamentally be strong as well.”
China’s foreign debt and current-account surplus stood at $293bn last year, which was the largest in the world.
In his counterargument, Seaman explains that under the CFETS index weighting which is used to inform the daily fix, the four largest currencies are the US dollar (26.4%), euro (21.4%), Japanese yen (14.7%) and Hong Kong dollar (6.6%) (see chart above).
But with the US dollar highly expected to strengthen and the Hong Kong dollar pegged to the greenback, it would require huge swings in the euro and the yen in order for the renminbi to weaken — neither of which is likely to happen.
While he agrees that US and Chinese monetary policies are headwinds for the renminbi, there are also potential tailwinds for the currency such as the possible inclusion of A-shares in major global indices such as the MSCI.
When that happens, almost every investor globally would find their China portfolio massively undersupplied and the easiest fix to that would be to buy into the renminbi, which will push the currency up.
“I think the renminbi is very undervalued and is likely to appreciate for many years to come,” Seaman said. “It could double in value over the next decade.”
The mystery of the new fix
The key to China’s transition to a less managed exchange regime lies in the new methodology to set its daily CNY/USD fix. While at first glance the concept seemed easy enough to understand, it has already undergone a number of changes since it was implemented last August.
When China first introduced the new regime, its instruction to market makers was that they needed to start taking into account the previous day’s interbank foreign exchange closing prices, the supply/demand dynamics of the market, and movements of other major currencies for their pre-open quotes to the China Foreign Trade System (CFETS).
More guidance came four months later when CFETS published an exchange rate index in December that is based on a basket of 13 currencies including the dollar, euro and yen.
And while the PBoC had not revealed which factors had the most influence on the fix, in the first few months of the new system it was clear that a lot of emphasis was being placed on the previous day’s close.
However, things changed in January when the PBoC reacted to the volatility at the start of 2016 by attempting to stabilise the currency. It resorted to keeping the fix steady and ignoring the previous onshore spot closing levels, according to Khoon Goh, senior FX strategist at ANZ.
But the adjustments did not stop there. The PBoC changed things again following the country’s return from the Chinese New Year holidays on February 15, which saw the fix set some 196 pips lower than the previous close.
Several market participants attributed a change of that magnitude to yet another shift to the way the fix was being managed. However, in the absence of any explanation from the central bank, market observers were left making educated guesses.
Thankfully, the silence lasted only until March when CFETS finally explained that the fixing regime was a combination of the previous close plus movements of a basket of currencies (see main story) that not only revolves around the CFETS index, but also the Bank for International Settlements (BIS) and Special Drawing Rights (SDR) baskets.
Having three currency baskets provides a better reference to deal with market volatility and is also consistent with market practices, the PBoC explained.
Still, ANZ’s Goh said the way China formulates its daily fixing is still very much up to interpretation and it is unlikely the PBoC’s operational strategies will ever be revealed.
“Perhaps then, the new arrangement for the fixing is to keep the market guessing and to use it more to guide the market, rather than having it being guided by the market,” he said.