Aidan Yao, senior economist at AXA Investment Managers (AXA IM), discusses the four key characteristics of China’s foreign exchange (FX) policy and how these impact the liberalisation of the renminbi’s (RMB) exchange rate.
The liberalisation of the RMB’s exchange rate should eventually give way to market forces to dictate price actions meaning that a medium-term depreciation of the RMB on a trade-weighted basis is within anticipation. The recent stabilisation in China’s FX market has removed the RMB from investors’ radar.
Part of this stability was driven by the weakness in the US dollar, which could be reversed if the Federal Reserve (Fed) resumes policy tightening around mid-year – a view that is not (yet) subscribed by the market. But some credit also needs to be given to the Chinese authorities for stabilising the economy and improving the transparency of their FX operations.
A significant increase in official communication (including by the Premier and the Governor of the People’s Bank of China (PBoC)) was testament to the latter. However, there are still lingering questions about China’s FX policies: what do the authorities want to achieve or avoid, and how they can accomplish these goals?
We believe that China wants to move towards a market-based exchange rate – one that is more reflective of economic fundamentals and relative competitiveness. This is why the yuan was de-pegged from the US dollar last year, and the exchange rate has been set increasingly against a basket of currencies and in line with market forces. The authorities have also stressed that the RMB is not heading for a large devaluation, and the commitment to maintain market stability is strong.
This means, in our view, that official interventions will likely remain a normal part of the FX operation in China for the foreseeable future. But contrary to popular belief, we see these interventions as a way to preserve financial stability, as opposed to dictating FX direction. Overall, China’s exchange rate policy resembles the characteristics of a “managed float” regime, with perhaps the “managed” part more prominent than the “float” part, for now.
We remain comfortable with our call of a medium-term depreciation of the RMB on a trade-weighted basis. The active FX management, provided that it is successful, will keep the process orderly and gradual. Back in late January 2016, we forecast a 3-3.5% depreciation of the RMB, and the official CFETS index has since fallen by more than 2% year-to-date. There are risks of overshooting in the near-term, but the outlook for the FX market is clearly clouded by the uncertainties about the Fed’s and China’s policies. We are inclined to keep our forecast unchanged at this stage, but remain ready to react to new developments.
Four characteristics of China’s FX policy
1)Shifting from the US dollar-peg to a currency basket: the un-peg of the yuan (CNY) from the US dollar (USD) marked an important milestone in the transition towards a market-based exchange rate. The PBoC later introduced a CNY CFETS index, which the official fixing of the exchange rate makes reference to (along with the Bank of International Settlements’ and International Monetary Fund’s special drawing rights baskets). Since the transition, both the realised and option-implied volatilities of the CNY/USD have increased significantly, suggesting that a de-link from the USD has indeed taken effect.
2) The yuan is more market-driven: The RMB exchange rate has gone through three phases: from pegging to the USD (prior to August 2015), to a tightened control of the fixing rate (second half last year after the August turmoil), to setting the fixing rate more in line with the market (recent months). Zooming in on phase 3 in the second chart below, one can see that the fixing of the CNY/USD has indeed moved in tandem with the USD DXY, with a daily correlation of more than 0.8 (after adjusting for trading time difference).
3) No large devaluation:China will not rely on currency depreciation to stimulate the economy was one of the key messages from the recent official communication. Despite all the fears of RMB devaluation, one has to place this move within the prospects for US dollar strength in general. As shown by the first chart below, the RMB was in fact among the best performing currencies over the past year. This was made positive by the official intervention to dispel depreciation pressure, even this was at the expense of running down FX reserves (second chart). Actions speak louder than words – these actions are consistent with China’s official desire to avoid competitive devaluation.
4)Financial stability is a priority: the authorities have undertaken two major FX market interventions – mid last year and early this year – both in response to market turbulence. But as conditions normalise, the extent of market interference has subsided, as reflected by the narrowing of reserve declines in recent months. Overall, we think that the authorities are using FX interventions to maintain financial stability, not to alter the direction of FX trends.
It is important to note that “no large depreciation” does not mean “no depreciation”, and “ensuring stability” does not mean “no market volatility”. The yuan has so far depreciated by some 2% year-to-date on a trade-weighted basis (despite strengthening against the USD), and FX volatility has risen. What the authorities want to see is a proper functioning of the FX market, without fears and panic driving financial instability and negative contagion to the real economy (via capital outflows). So long as the moves are consistent with fundamentals, and not accompanied by turmoil, we think the authorities would be happy to let market forces dictate price actions.