China’s currency, the renminbi, depreciated 1.4% in February 2014, essentially tying the record for the largest monthly drop since the Chinese government’s “peg” policy officially ended in 2005. This jump raised the question of whether or not the renminbi has come to some turning point or just another road bump before resuming a 9-year modest bull rally. We believe the recent depreciation of China’s renminbi is government-engineered and potentially signals a change in China’s exchange rate policy.
In 2013, the renminbi (abbreviation CNY), also called the yuan, was among the top 5 best performing emerging market currencies to appreciate against the U.S. dollar (USD), rising 2.9%. The seeming one-way trend in the currency, and, more importantly, the widening interest rate differentials between China’s onshore version of its currency (CNY) and its offshore version (CNH) has led to capital inflows domestically and from offshore investors.
The People’s Bank of China Engineering Weakness
Over the last 2 weeks, the renminbi has seen the largest weekly decline since 2011. With the expectation that the Chinese government is behind this move, there are signs the People’s Bank of China (PBoC) wants greater two-way movement in foreign exchange (FX).
First, the PBoC is concerned about the speculative buildup of long CNH/CNY positions. This is apparent by the notable surge in foreign exchange reserves in 2013 that rose by $433bn as shown in the following chart. We calculate that after accounting for the trade surplus and foreign direct investment, hot money pouring into China’s economy totaled $150bn. This figure could be an underestimation, as economists suspect that some of the capital inflows are disguised as trade flows, such as from the over-invoicing of exports concerns raised recently.
One way to measure the valuation of the exchange rate is to look at the size of the current account balance. The renminbi’s steady appreciation has led to a meaningful adjustment in China’s current account surplus from 10% in 2007 to 2% in 2013 (the chart shows the renminbi in dollar terms, so think in reverse). We would not be surprised to see a balanced current account in the next 2 years. Finally, one of the International Monetary Fund’s (IMF) fair value model indicates the real trade-weighted value of CNY is now within the range of its fair value.
Medium-term Outlook for the Renminbi
We expect the CNY Real Effective Exchange Rate (REER) to begin tighter “range-bound” trading with greater volatility rather than the prior moderately appreciating path during the last few years. Here are the likely dominant factors:
- From a REER perspective, CNY remains vulnerable as inflation has been running at 3%, approximately 1% above its trading partners. This could put downward pressure on CNY.
- The prospect of a shrinking current account surplus, perhaps to a balanced one, as the services deficit continues to expand.
- Capital account liberalization, such as allowing domestic firms to invest overseas, is likely to increase outflows.
- The ongoing trend of outward foreign direct investments by Chinese multinationals is expected to continue.
China’s Change in FX Policy
We believe the government is looking to change FX policy, most likely by widening the daily trading range for the renminbi from +/-1% to +/-2%. This would allow for more two-way risk in the FX. While we believe the government is looking to change its FX regime, it is unlikely to change course in a more dramatic manner such as extended depreciation or devaluation for these reasons:
- Rise in Chinese corporate FX exposure. According to data from world economics researcher CEIC, China’s corporate sector has increased its dependence on short term FX financing (see next chart). Short term external debt has risen from $200bn in 2009 to approximately $625bn in 2013. A devaluation or sustained depreciation will raise the costs to repay its debt obligations. More volatility is likely to lead to a leveling off of short term external debt.
- Domestic rebalancing. If Chinese policymakers are serious about correcting the imbalances in the economy (less dependence on investment led growth and more on services), a stable-to-strong currency should aid in that process by boosting imports of consumption goods etc. and raise the costs for investment and export goods.
- Foreign Exchange. A move to a more flexible but volatile FX regime is likely to have a modest and variable impact against Asian currencies. According to our correlation analysis, the Taiwan dollar, the Singapore dollar and the Malaysian ringgit would be most affected by any move in CNY with an approximate positive correlation of 0.3. The Japanese Yen and South Korean Won would be less affected while the Euro has had a negative correlation with CNY.
- Equity Markets. A change in China’s FX policy could benefit Chinese exporters, particularly low-to-mid end exporters that have suffered from a stronger FX and rising labor costs. There could be more notable and sustained outperformance for this sector if the long term CNY appreciation has come to an end or is in a long period of consolidation.
- Fixed Income. In general, fixed income has underperformed due to tighter monetary policy. The steady appreciating trend in FX helped offset the poor bond fundamentals to some extent. Greater volatility in FX could erode interest in the fixed income markets.
What does this mean for Global Corporations?
Global multinational corporations have grown accustomed to steady appreciation in China’s currency. As a result, they have not repatriated their earnings back to their respective home headquarters. They’ve enjoyed the low volatility of the renminbi.
A change in China’s FX regime will likely inject more currency volatility and could potentially reverse its upward trend, posing new challenges for multinationals. With a potential change in China’s exchange rate system and the difficulty in repatriating earnings, multinationals could arrest expansion activities in China. That would dramatically slow foreign direct investment.
In other words, any moves by China toward capital account liberalization could lead to net outflows and be a further headwind to the renminbi’s appreciation.
We believe the recent depreciation of the Chinese renminbi is government engineered, part of the process of injecting volatility into the exchange rate, with its broader aim being to internationalize the renminbi. If our view that the renminbi’s valuation is at fair value is not correct, then hot money and other capital flows will continue to exert appreciating pressures. That makes it imperative China move more quickly to make the renminbi fully convertible. Otherwise, imbalances such as ballooning FX Reserves will make its exchange rate policy more difficult to manage than it already is.