Questions About the Renminbi’s Stress

17 Jul 2018

Too often we… enjoy the comfort of opinion without the discomfort of thought. John F. Kennedy

The rapid pace of correction of the renminbi exchange rate recently has surprised the market.  What have changed to trigger the slide?  Is China finally shifting to a devaluation policy?  Will it surprise the market again by rebounding later?

Concerns about escalating Sino-US trade tensions have rattled the renminbi, which has given back all its 1H 2018 gains against the USD within just a few weeks recently.  Its sharp fall has also raised the suspicion that Beijing might have shifted to a devaluation policy to fight the trade war.  I beg to disagree.  In addition to other reasons, Beijing will not want to repeat the experience in August 2015 when the PBoC reformed the renminbi fixing mechanism but the market misread it as a devaluation move, causing massive capital outflows and wreaking havoc the renminbi and the global markets.  It took Beijing almost two years to stabilise capital flows with capital controls.

 

Is the PBoC devaluing the renminbi?

I have long argued[1] that devaluation would not be effective in boosting Chinese growth, and that the renminbi would have to be devalued by 20% and 40% against the USD if it were to yield any material impact for China.  This would be unacceptable for everyone.  So the four-percent decline in the CNY-USD cross rate since June is meaningless from a policy perspective.

Crucially, evidence from the PBoC’s usage of the “countercyclical factor” in the fixing mechanism[2] shows that it has actually been leaning against, but not pushing for, the renminbi’s decline.  The calculation of this factor showing the PBoC using “brute force” to set the CNY-USD fixing against market direction is unknown.  But a market study[3] estimates that the PBoC had been using the countercyclical factor to set the fixing to counter a falling renminbi recently.  The purpose was to prevent disorderly renminbi depreciation but not to encourage it.

 

Why the sharp fall?

In my view, it is not the China-US monetary policy divergence that is driving down the renminbi, as most observers have casually argued.  That policy divergence has emerged since 3Q 2017 when the PBoC started cutting the bank reserve requirement ratio (i.e. easing liquidity) while the US Fed embarked on normalising US interest rates.  But the CNY was appreciating against the USD all the way until this June.

Crucially, the two key assumptions behind the interest rate parity theorem – namely an open capital account and perfect substitution between USD and RMB assets – which observers often use to bet on renminbi movement (mostly devaluation) have limited relevance to the CNY market!  It may apply to the CNH market which is not subject to direct PBoC control.  But still, the CNH market is not totally free from intervention, as the PBoC can still intervene in the offshore (Hong Kong) renminbi interbank market to affect CNH liquidity, as it did in 2016[4].

The renminbi’s recent decline is an overdue correction of its excessive strength between mid-2017 and May 2018 when strong portfolio inflows (Charts 2 and 3) overwhelmed the drag on the currency from a small current account deficit in 1Q.  The USD’s weakness early this year also exacerbated the renminbi’s strength.  But the escalation of Sino-US trade tensions has shaken the market’s complacency about China’s risks[5].  When weakening economic data started flowing in May, the renminbi’s fortune also turned.

 

 


[1] See “Chi on China: What Lies Beneath China’s Renminbi Shock?”, 9 September 2015, “Chi Time: Renminbi Devaluation Not China’s Best Option”, 7 May 2014, and “Chi on China: Up or Down? The Knowns and Unknowns of the RMB New Normal”, 28 January 2015.

[2] For a discussion on the “countercyclical factor” in the fixing mechanism, see “Chi Time: Why Does the PBoC Fiddle Around With the Yuan Fixing Again?” 1 March 2017.

[3]Reluctant RMB Depreciation Will Continue But Remain Moderate”, Natixis, 6 July 2018.

[4] See “Chi on China: RMB Internationalisation (part 1 of 2) – Short-term Tactics May Have Changed”, 24 February 2016.

[5] See “Chi Time: A-Shares Tanked. What’s Next?” 11 July 2018.

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