Markets like to draw lines in the sand and were always likely to react to the Chinese renminbi weakening beyond 7.00 to the U.S. dollar. Markets like round numbers and attach psychological importance to levels that are easy to remember. The belief among some market participants that policymakers in China were also wedded to certain levels may have added to the surprise element of the move above 7.00 for some.
In June, the governor of the People's Bank of China (PBOC) tried to disabuse some market participants of this notion. In an interview, Yi Gang noted, "I don't think along this mathematical scale, any number is more important than other numbers." He added that "There is obviously a link between the trade war and the movements of renminbi," and the bilateral exchange rate is "basically determined by supply and demand of the market force, so that it's basically a market mechanism."
With the governor's comments in mind, S&P Global Ratings believes the key fundamental that changed over the past week is the risk of higher U.S.-China trade and technology tensions. The move of the renminbi through 7.00 is consistent with China's exchange rate policy framework of the last two years or so. Put simply, the policy since 2016 has been to focus more on the stability of the currency versus the trade-weighted basket (in which the U.S. dollar has a 27% weight if we also include the pegged Hong Kong dollar) and allow market forces to play a greater role. The obvious implication of such a policy is more volatility in the bilateral rate versus the dollar.
A structural rise in USDCNY realized volatility is exactly what we have seen up until recently. As the exchange rate neared 7.00 and U.S.-China negotiations were scheduled, so realized and implied volatility began to fall (see chart 1).
The timing of the move beyond 7.00 is clearly not a coincidence and may have a political dimension. There was some evidence that leading into negotiations with the U.S., the PBOC had been "leaning against the wind" to restrain depreciation. The central bank does this by using the so-called "counter-cyclical buffer" to provide some discretion in setting the daily fixing of the onshore USDCNY rate. When the fix deviates a little more than usual from the rate implied by the market close and overnight FX movements, markets interpret this as a signal about PBOC preferences and possible intervention to prevent the currency from moving too fast. In recent months, this signaling had been consistent, pointing to a preference for stability close to, but not weaker, than 7.00. This also resulted in declining realized volatility.
While the timing may raise concerns that big currency policy changes are afoot, so far, we have not seen any evidence that the overall policy framework has changed. The USDCNY move of more than 2% since the U.S. trade policy shock is larger-than-average. However, knowing what we know now, perhaps this should not be a surprise. First, we received unexpected news of a possible hike in U.S. tariffs. Second, markets repriced volatility as it became clear that renminbi risk was two-tailed around the 7.00 level (as it should be for any genuinely flexible currency)
The renminbi remains more stable against a trade-weighted basket of currencies (see chart 2). The renminbi is about 5% weaker than its strongest level since January 2018 versus the China Foreign Exchange Trading System index (or the CFETS index). This index was launched by CFETS (a subsidiary of the central bank) to help shift the anchor of expectations from the dollar to a broader range of currencies. Not a large move, and smaller than the 12% depreciation versus the strongest level versus the dollar over the same period.
Renminbi depreciation can raise concerns about large capital outflows and financial instability but we think these risks are manageable. Of course, market expectations can be self-fulfilling and it is unwise to rule this out. Still, we would point to differences between crossing 7.00 now and the volatile period of 2015-2016:
- Markets are less concerned about a hard landing in China. Activity data have stabilized in recent months and some moderate policy easing is still in the pipeline;
- Policymakers are maintaining policy continuity rather than introducing a surprise regime change;
- Property developers--China's largest offshore borrowers--face tighter onshore funding conditions, which means they are unlikely to rush to retire dollar debt; and
- Tighter capital flow measures are largely working for now, although there remains some leakage from the balance of payments (BOP).
The outlook for the renminbi will depend mainly on trade-tech tension but we do not expect a substantial depreciation. If the situation stabilizes and global growth evolves as we expect, the renminbi should range trade around current levels versus the dollar and against the CFETS index. Before this most recent move, China's BOP was fairly balanced with little change in valuation-adjusted foreign exchange reserves, suggesting the renminbi was not substantially misaligned.
At the same time, we expect China to tolerate some flexibility because heavy-handed currency management often proves counterproductive. What appears to be stability--softly pegging the renminbi versus the dollar and suppressing volatility today--can in fact lead to abrupt changes and more volatility in the future. This problem became apparent even in the last few months as PBOC leaning against the wind encouraged markets to underprice the risk of a move above 7.00. Then, when a move subsequently occurs, the abrupt repricing of volatility causes a larger-than-average move and raises concerns about a policy regime change.
The implications for macroeconomic policies--so long as China avoids destabilizing capital outflow--are limited, in our view. Cyclically, depreciation will partially absorb the impact of tariffs, reducing the burden on other policies to support growth. Structurally, allowing more flexibility in the currency provides more space to set policies according to domestic objectives such as growth, inflation, and financial stability.
Exchange rates across Asia-Pacific will face depreciation pressures if renminbi weakness persists, consistent with our finding of a new "renminbi bloc." We presented evidence in our recent commentary ("APAC Economic Snapshots: Trade Wars And Currency Concerns," published on June 25, 2019) that the renminbi has become a more important influence on a range of Asian currencies, both in developed and emerging markets. The dollar retains its importance for some currencies, especially those associated with current-account deficit economies but we see a very strong paradigm shift from being firmly in a "dollar bloc" to having higher sensitivity to movements in the renminbi. This reflects China's rising share in global trade and its emergence as a price setter rather than a price taker.
In turn, emerging market central banks in Asia-Pacific may show more caution in easing monetary policies given renminbi depreciation. Some economies fund their current account deficits in dollars or with bond portfolio inflows from exchange-rate sensitive investors. As currency volatility versus the dollar rises, so the risk premium on some emerging market assets will rise. As we have seen in Asia over recent years, central banks often take a cautious approach to cutting rates in such an environment.
This report does not constitute a rating action.
|Asia-Pacific Chief Economist:||Shaun Roache, Singapore (65) 6597-6137;|
|Asia-Pacific Economist:||Vincent R Conti, Singapore + 65 6216 1188;|
|Vishrut Rana, Singapore (65) 6216-1008;|
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