On December 11, 2015, the People’s Bank of China (PBoC) announced a new renminbi (RMB) exchange rate index that sent a clearer message about a significant shift in the way the PBoC manages its exchange rate. The key reason for the change was to shift the focus away from USD/Chinese yuan (CNY) to RMB TWI.
Two Major Implications from the FX Regime Change
- The alleviation of pressure on RMB due to persistent and growing capital outflows by allowing USD/CNY to move higher. There are two main factors behind capital outflows accelerating in China. First, market expectations of a gradual CNY depreciation going forward. Second, the start to the Fed’s rate tightening cycle is leading to a narrowing in interest rate differentials between the U.S. and China. This has been leading to an unwind of USD debt by the Chinese and asset allocation away from China.
- The introduction of the RMB basket would allow the PBoC to front run the Fed tightening cycle. It would allow the PBoC to avoid CNY appreciation at a time of a broad USD rally.
We expect the USD/CNY to gradually depreciate going forward with the divergence in monetary policy between the Fed and PBoC in 2016 as the Fed begins to normalize interest rates and the PBoC eases policy further in response to weaker economic activity and volatile financial market conditions. In the absence of persistent PBoC intervention, the RMB will feel the pressure from capital outflows that has become a persistent headwind, although risks still look manageable.
Emerging Markets Asia
A likely modest depreciating trend in the RMB could drive USD/EM Asia higher. The link connecting the two is weak domestic growth concerns and export competitiveness. We look at the correlation between RMB and Asian currencies to determine which currencies are more vulnerable to a weaker RMB.1 Our analysis reveals that the Taiwan dollar (TWD), Singapore dollar (SGD) and Malaysian ringgit (MYR) are most correlated with RMB at 0.30. While on the surface this may not seem high, we believe it is significant for the following reasons:
- If FX is perceived to be a random walk, then 0.30 is high
- China’s FX regime is highly managed so it distorts the results
We believe that, with a change in its FX regime to a more market-oriented one, RMB price action should become more predictable and therefore more correlated. To prove our hypothesis, we looked at the period immediately following the end of the RMB peg in July 2005.
1. Correlation is the degree to which asset class price have moved in relation to one another. Correlation ranges from -1 (always moving in opposite directions) through 0 (absolutely independent) to 1 (always move together).