Since 2014, the People’s Bank of China (PBoC) has pursued a renminbi policy that targets a stable trade-weighted exchange rate based on the CFETS basket instead of a stable CNY-US dollar cross-rate. However, it has also made tactical adjustments to this ‘stable renminbi’ policy from time to time, depending on market sentiment and US dollar movements. These policy nudges have, in turn, caused confusion in financial markets about China’s foreign exchange policy intentions. In managing onshore foreign exchange sentiment to try to minimise capital outflow pressures, the PBoC realises that what matters most is the CNY-US dollar cross rate, not the tradeweighted exchange rate (nor the CFETS Index). When sentiment on the renminbi has been stable and the US dollar strong, the PBoC has allowed the renminbi to depreciate against the dollar so as to keep the trade-weighted exchange rate stable. In other words, the PBoC has used the CNY-US dollar cross-rate as an adjustment factor to anchor a stable CFETS Index. This approach was used between 2015 and 2016 when the dollar strengthened against all currencies in the renminbi basket, putting significant upward pressure on the trade-weighted index. To arrest that upward pressure, the PBoC allowed the renminbi to drop against the dollar.
However, when renminbi sentiment became extremely negative and volatile, causing rampant capital outflows, the PBoC shifted back to targeting a stable CNY-US dollar cross-rate and allowed the CFETS Index to adjust. In other words, a stable CNY-US dollar cross-rate was contingent upon poor renminbi sentiment. These short-term tactical shifts were seen throughout the 2015-2016 period. This foreign exchange policy tactic was used intermittently until early this year when the PBoC allowed the trade-weighted exchange rate to fall, even though the sentiment on the renminbi had improved significantly since the start of the year. The PBoC should have moved to keep the trade-weighted exchange rate stable, but it did not.
What is going on has a lot to do with the change in the direction of the US dollar and economic conditions in China. Contrary to market expectations early this year, the dollar has actually weakened, not strengthened. At the time of writing, the US Dollar Index has fallen by more than 3% from January, while the CNY-USD cross-rate has been stable since its 1% jump in early 2017. So the CFETS Index has followed the dollar down. The PBoC has shifted its foreign exchange policy again to take advantage of the weaker dollar to depreciate the trade-weighted exchange rate while keeping the CNY-USD crossrate stable, even though the sentiment on the renminbi has improved (Figure 2). It is notable that this change in tactics has come on the back of fading capital outflows due largely to a decline in the repayment of foreign liabilities by Chinese firms and effective capital controls. As a result, sentiment towards the renminbi has improved, as seen from a rising ratio of FX-settlement-to-FX-receipts by Chinese bank clients (Figure 3). This reflects a rise in the percentage of foreign currency actually sold in the market out of foreign exchange receipts, and thus indicates that domestic foreign currency recipients intended to sell more foreign currency and hold more renminbi.
However, the PBoC still wants to depreciate the trade-weighted exchange rate, despite these positive developments, to generate some growth momentum for the domestic economy. It is thus arguably pursuing a ‘dirty float’ foreign exchange policy anchoring on the CFETS Index. With economic recovery taking hold, we believe it is likely that it will shift back towards a stable trade-weighted foreign exchange policy soon. With sentiment on the renminbi turning positive due to a stabilising Chinese economy, declining capital outflows and receding worries about China’s debt crisis (due to the narrowing gap between China’s credit and nominal GDP growth), should the US dollar weaken further, a return by the PBoC to targeting a stable CFETS Index would point to a strengthening renminbi against the US dollar in the coming months. There is a fair chance that the renminbi would then end this year by appreciating to less than 6.9 renminbi per dollar. For investors, one implication of this is that it could make Chinese (notably fixed income) assets more attractive, assuming that regulatory tightening ends before the 19th Communist Party Congress later this year.Download to read more