FX Watch – CNY: Short-term strength, modest depreciation in long run

by: Georgette Boele , Arjen van Dijkhuizen

  • In 2016 the Chinese yuan declined by 6.5% versus the US dollar
  • So far this year the yuan has recovered by 2.4%
  • Chinese authorities have steered the yuan higher…
  • … to contain capital outflows …
  • …and to manage the relationship with the US…
  • We expect near-term support for the yuan…
  • …but a modest yuan depreciation in the long run
  • Our new end of year forecasts are 6.80 (2017) and 6.90 (2018)
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Recent developments

Last year, the Chinese yuan weakened by around 6.5% versus the US dollar because of a general US dollar strength, higher US Treasury yields, Fed rate hikes and the drop in Chinese FX reserves primarily caused by rising capital outflows. So far this year, the yuan has strengthened by around 2.4%, which has mainly taken place since the end of May. The recent yuan appreciation was to a large extent driven by the PBoC’s introduction of the counter-cyclical adjustment factor (more on this below) in the fixings formula. There has also been speculation that Chinese authorities intervened in the yuan. The Chinese yuan is still heavily managed. In this FX Watch we focus on the short term and longer term outlook that drive the yuan exchange rate.

Stronger yuan (policy) aimed at taming capital outflows …

In our view, a key reason why the Chinese authorities have tweaked their exchange rate policy to support a firmer yuan versus the US dollar stems from their aim to ease capital outflows. Over the past few years, rising capital outflows have been the key driver of the drop in China’s FX reserves (by around 25% between the peak in June 2014 and January 2017, to around USD 3 trn). The authorities reacted in late 2016, tightening capital controls by making it harder for companies and individuals to transfer foreign currency abroad. What is more, as yuan depreciation expectations have proven to be an important driver of capital outflows, Beijing also took steps to support the yuan versus the US dollar. The PBoC has steered money market rates higher, for instance by raising the rates for its open market and lending facilities by 10-35 bps. There has also been speculation that Chinese authorities have stepped up interventions in the yuan.  More recently, the PBoC changed its currency fixing methodology by adding a so-called ‘counter-cyclical factor’, reducing the weight of market components in the fixing.  In our view, the timing of these moves also was related to the Fed’s rate hike path (the Fed hiked its policy rate by 25 bp in March and June). All in all, the shift in exchange rate policy has helped to strengthen the yuan versus US dollar and to stem capital outflows, with FX reserves rising for the fourth consecutive month in May.

… and at safeguarding US-China relations

Another important reason why the authorities have engaged in a ‘stronger yuan policy’ over the past half year stems from Donald Trump’s victory in the US presidential elections last November. Trump was vocal in his election campaign, accusing Beijing of unfair exchange rate policies and trade practices. Although the yuan initially depreciated after Trump’s victory (fitting within a broader picture of dollar strength those days), the subsequent appreciation of the yuan versus US dollar has supported US-China relations. Bear in mind that the US also needs China to keep North Korea in check. In our view, bilateral relations have improved further after the Trump-Xi Jinping summit in April, which resulted in a bilateral 100-day action plan on trade. Presumably, currency issues have also been discussed at that meeting. Trump has stopped accusing China of currency manipulation and the US Treasury has not labelled China officially as such in their April review (although it has kept China on the ‘watch list’, together with Japan, South Korea, Taiwan, Germany and Switzerland).

The road to yuan internationalisation will be lengthy and not a straight one …

Going forward, an interesting issue affecting exchange rate developments is the longer-term path to further internationalisation of the yuan. Of particular interest in this respect will be Beijing’s strategy towards adopting a more market-oriented exchange rate policy and towards the liberalisation of the capital account. A couple of years ago, the Chinese authorities took several steps in these areas, to increase the likelihood that the IMF would include the yuan into its SDR basket, a prestigious milestone for Beijing. They had for instance set up a deposit insurance system and liberalised interest rates to some extent. The PBoC also took steps to introduce more market elements into the exchange rate policy, triggering market panic in mid-2015 (repeated in early 2016) as these moves were communicated poorly.

… as steps toward liberalisation of exchange rate and capital account …

After the IMF’s decision in November 2015 to include the yuan in the SDR basket (effective per 1 October 2016), the authorities have taken further steps to liberalise the capital account. They have for instance opened up the domestic interbank bond market for foreign institutional investors (central banks, sovereign wealth funds, large pension funds and insurers) and have also opened onshore FX derivative markets, improving the possibility for foreign investors to hedge currency risks. Initiatives such as the Stock Connect and Bond Connect schemes as well as the recent inclusion of some China A shared into the MSCI EM Index also will help to support portfolio flows into China over time.

… have been followed by tighter controls when stability goals became urgent

However, as happens more often in China, the road to liberalisation is lengthy and not a straight one. The authorities have repeatedly decided to backtrack on longer-term strategic goals, if short-term stability goals demand it. After abandoning the de facto peg to the US dollar and moving to a peg versus a basket in 2015/2016, they have in fact recently attached more weight in steering the yuan versus the US dollar again for the reasons mentioned above. The introduction of an anti-cyclical component in the fixing methodology is a case in point. Moreover, the tightening of restrictions for capital outflows in late 2016 is understandable from a macro point of view, but not really in line with the longer-term goal of capital account liberalisation. We expect this dual approach to continue, with Beijing committing to long-term goals of liberalisation while in the meantime adjusting its path if stability considerations are more urgent.

Conclusion

Our long-term view is that is that the opening up of Chinese financial markets will result in the yuan being driven to a higher extent by market forces. We think that China’s longer-term economic and political risks are currently not fully reflected in the pricing of the yuan. According to BIS data, the yuan has weakened by around 10% in real effective terms since 2015, but that follows a 50% real effective appreciation in the previous ten years. All in all, we expect the yuan to depreciate further in the longer-term, although we maintain our view that Beijing will not tolerate a sharp depreciation versus US dollar.

However, in the short run, other factors play a crucial role. The Chinese authorities are still vigilant in terms of managing capital outflows and FX reserves. Beijing will also remain careful in mending relations with the US. This will support the yuan.  Moreover, the US dollar uptrend peaked around the turn of 2017. The US dollar weakness wave is only at an initial stage and we expect more weakness ahead across the board. Therefore it is likely that the Chinese yuan will also feel upward pressure versus the US dollar. However, the Chinese authorities will prevent too much of a strengthening of the yuan across the board.

What is more, global central banks seem to be moving gradually towards less accommodative monetary policy (with the Bank of Japan being the exception for now). Also the PBoC is pursuing targeted tightening. This development will make investors more cautious in building up carry trades to profit from the interest rate spread. They will likely focus on currencies that have a higher carry buffer. This development will probably also support the yuan. Finally, central bank reserves’ diversification will over time increase demand for the yuan.

So in short, longer-term dynamics still favour a weaker yuan in our view, because of the anticipation of economic and political risks, while short-term developments are supportive for the yuan. To reflect these dynamics we have adjusted our USD/CNY forecasts for end-2017 and end-2018 to 6.80 and 6.90 – from 7.00 and 7.10 –, respectively (see table below).