Calling a Bottom for the Renminbi: Recent Depreciation Trend Set to End

  • The Chinese currency has depreciated significantly so far in 2016, reaching a six-year low against the US dollar and weakening 5.4% in trade-weighted terms. This has resulted from asymmetric central bank policy, which is biased towards depreciation.
  • But in contrast to the panic in early January, global markets have reacted remarkably calmly to the steady depreciation of the CNY since early May. The pace of expected depreciation on forward markets has declined to low levels.  
  • This is because markets are less worried now about China’s economy and about the risk of a push for a sharply weaker currency to ‘crowd in’ growth. Also the depreciation has been nicely gradual, and – importantly – net financial capital outflows have declined to levels that are broadly sustainable.
  • Meanwhile, the composition of outflows continues to evolve. While repayment of foreign loans remained high through Q1, foreign lending by Chinese banks came down substantially (probably at the behest of policymakers), as did repatriation of foreign financial capital. But outflows of potentially mobile financial assets from China’s domestic system also stayed high and remain an issue going forward.
  • In our analysis, the CNY weakening since end-July 2015 has broadly removed the overvaluation of the real effective exchange rate (REER) that had developed in 2015. Looking ahead, we expect the CNY to remain under some modest pressure in the short term, largely from some expected US dollar strength as the US Fed raises interest rates – but we do not expect market pressures to be very large.  
  • It is key to take into account what policymakers want to see and do. While they will be pleased that the CNY overvaluation has basically been removed, we think that they will not want to see a significantly undervalued CNY.
  • Overall, we expect the CNY to weaken somewhat further, reaching 6.8 against the US dollar by end-2016 and 6.9 at the end of Q1 2017, largely because of the modest global strengthening of the US currency that we expect amid US Fed rate normalization.
  • There is a risk, though, that pressures on the CNY would rise more substantially because the US dollar strengthens more sharply against other currencies globally and/or net financial capital flows out of China rise significantly again.
  • We maintain that in the medium and long term the CNY should appreciate again versus high-income currencies such as the US dollar.

FX policy shift, market calm

The CNY has weakened substantially in recent months, especially since early May. It reached 6.7 to the US$ in the second week of July, a level not seen since 2010, before strengthening marginally. It has also depreciated in trade weighted terms. Versus the authorities’ CFETS basket, it weakened 6.4% through the second week of July, before rising 0.8% in the last 10 days.

This weakening has resulted from asymmetric People’s Bank of China (PBoC) policy, biased towards depreciation. When the US dollar strengthened globally, such as in January and since early May, the CNY depreciated against the greenback. And when the US$ weakened globally, such as in March and April, the CNY strengthened vis-à-vis the US dollar. 

But, on balance, the CNY depreciation against a strengthening US$ was larger than the appreciation against a weakening US$ in the first half of the year. As a result, the depreciation of the official basket was five times as large as the 1% weakening of the US nominal effective exchange rate (NEER).

Nonetheless, markets have reacted very calmly to this weakening of the CNY, both domestically and internationally. On forward markets the expected depreciation 12 months ahead is now only 2.1-2.3%. In contrast, in early January, amid small moves in the CNY/US dollar, the markets expected 3.6-6% depreciation 12 months ahead.

Markets have responded differently in part because, compared with early January, they are less worried now about the state of China’s economy and the associated possibility that the authorities may drive the currency down sharply to ‘crowd in’ growth. Also, the recent CNY depreciation has been nicely gradual.

Financial capital outflows have subsided. In recent months net financial outflows have been US$20-30 billion a month, a level that can broadly be sustained without depleting FX reserves

Good news: Outflows are subsiding     

Another major reason behind the sanguine response is that financial capital outflows have subsided. In late 2015 and early 2016, net financial outflows reached US$100-140 billion per month.  

Since February, they have come down substantially, following vows by policymakers to not sharply depreciate the exchange rate. Various measures have also been implemented, including stricter enforcing rules restricting financial outflows and, apparently, asking the banks to tone down foreign lending.

As a result, in recent months net financial outflows have been US$20-30 billion a month, a level that can broadly be sustained without depleting FX reserves, given China’s current account surplus.

But watch mobile financial assets

Meanwhile, the composition of the outflows continues to evolve. We can usefully break down the financial flows into a few distinct types. Some types are less worrisome than others, since the authorities can, in principle, influence them relatively easily and/or they are unlikely to become large enough to become a major problem.

This is especially true for the repayment of foreign loans by Chinese corporates and local government vehicles and for new foreign lending by Chinese banks. Since the downward pressures on the CNY started to be felt, Chinese corporates have been repaying foreign loans in a big way, and this continued in Q1 2016, when it led to a net outflow of US$69 billion.

Foreign lending by Chinese banks, which resulted in a net outflow of US$71 billion in Q3 2015, has been brought down since then – likely at the behest of policymakers – and led to a net inflow of US$10 billion in Q1, as repayments exceeded new lending.

A third distinct type of financial flows is from foreign financial capital in China. We also do not worry too much about this as, unlike foreign direct investment (FDI), the total stock of foreign financial capital is modest. In Q4 2015, large-scale repatriation led to a net financial outflow of US$63 billion. However, in Q1 2016, this had decreased to US$9 billion.

The remaining type constitutes flows of Chinese financial capital other than via foreign lending. This includes portfolio flows and flows resulting from changes in holdings of foreign deposits and currency, as well as changes in “other foreign assets” and errors and omissions.

These types of flows are in principle the most worrying, because they could be large. We estimate that relatively mobile financial assets in China equaled around US$18.4 trillion in end-2015. 

Such outflows could potentially be sustained at a high level for a long time if sentiment and expectations on the CNY worsen substantially. That is why the government has strived to contain them and why they need to be watched going forward.

This type of outflow decreased in Q1 2016 but was still US$70bn. In all, net financial outflows dropped from US$215bn in Q4 to US$146bn in Q1.

We have recently revised our CNY forecast somewhat and now expect it to reach 6.8 at the end of 2016 and 6.9 at the end of Q1 2017, largely because of the expected strengthening of the US dollar associated with Fed tightening

CNY no longer overvalued

In the 11 months through end-June 2016, China’s trade-weighted exchange rate has depreciated by 6.2% in nominal terms, according to the BIS, the broadest and internationally recognized basket.

The depreciation of the real effective exchange rate (REER) was about the same at 6%, as China’s CPI inflation has broadly equaled the average of its trading partners.

Combined with some ongoing appreciation of the equilibrium REER, this weakening of the actual REER has broadly removed the overvaluation of the CNY, according to our measurement.

Outlook

In the short term, we expect the CNY to remain under some modest pressure. This mainly stems from some expected US dollar strength amid rising US Fed interest rates. Our US colleagues expect one more US Fed rate increase this year, and two in 2017.

Other major central banks, including the European Central Bank, will not be raising interest rates any time soon. This will lead to some more global US dollar appreciation. However, we do not expect this appreciation to be large – we forecast the greenback to rise only mildly against the euro to 1.08 by end-2016 and to 1.05 by end-2017, compared to 1.11 now.

In addition, some loss of growth momentum in China in H2 may exert some downward pressure on the CNY. However, in our baseline scenario, we do not expect market pressures to be very large.

Apart from these market pressures, it is key to take into account what policymakers want to do and see in China’s case. As discussed above, the CNY depreciation of the last year has basically undone the overvaluation that had emerged earlier on. Clearly, China’s authorities will be pleased to see that the overvaluation has diminished substantially.

However, we do not think they are keen to move to a situation where the CNY is (perceived to be) significantly undervalued, internationally. The PBoC has in the past shown that it realizes that a significant undervaluation leads to an increase in the current-account surplus to a level that will be (perceived to be) too high, internationally.

The central bank will be keen to avoid such international complaints. In September, the G20 meet in Hangzhou and the inclusion of the CNY in the IMF’s SDR basket in October is also likely to limit the appetite for a weaker currency among policymakers, if history is any guide.

We have recently revised our CNY forecast somewhat and now expect it to reach 6.8 at the end of 2016 and 6.9 at the end of Q1 2017, largely because of the expected strengthening of the US dollar associated with Fed tightening.

The key risk to this baseline forecast is that market pressures on the CNY increase substantially, either because the US dollar appreciates sharply against other currencies or, in a context of worsening sentiment vis-à-vis China and its currency, net financial capital outflows rise again in a major way. 

Over the medium and long term, with prices in China still only around half of those in the US, trend real effective exchange rate appreciation should continue as long as catch-up and relatively rapid productivity growth continue, even if the pace of trend REER appreciation in the coming ten years will fall short of what we saw in recent decades.

With China basically a low inflation emerging market, we expect most of this trend REER appreciation to take place in the form of nominal exchange rate appreciation, rather than relatively high inflation

About the Author

Louis Kuijs is Head of Asia Economics at Oxford Economics. This article is excerpted from China: The CNY Outlook After the Recent Depreciation, a research briefing report published on 21 July 2016.

Copyright © 2016 Oxford Economics. All rights reserved.

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