Abstract: Under the influence of the Russia-Ukraine conflict, Fed's rate hikes, and domestic resurgence of Covid cases, April has seen increased volatility in China’s currency and stock market. The sharp swings in the price of RMB could be explained by the rise of the US dollar index. If the dollar index continues to climb, the RMB may suffer from periodic weakening. But considering that the RMB has accumulated a large appreciation in the past year or so, adjustment in line with market conditions is not necessarily a bad thing. Such depreciation could in fact support domestic monetary policy in bolstering exports and economic growth. If China wants to stabilize growth, it will have to level up relevant policies, especially for infrastructure investment.
I. STRONG US DOLLAR LEADS TO WEAK RMB: THE EXCHANGE RATE WILL NOT RESTRICT CHINA’S MONETARY POLICY
Q: Since April 19, the RMB to USD exchange rate has been highly volatile. What do you think are the reasons for such fluctuations?
Wang: The fluctuations in the exchange rate of RMB could be explained by the rise of the US dollar index.
As inflation in the US continues to soar and the market prepares itself for more aggressive tightening by the Fed, the US Treasury yield has recorded a substantial rise recently. As a result, the interest rate spread between China and US is narrowing and even turning negative. The price of RMB used to be pushed up by the strong demand for forex settlements in the export sector, but now, with expectation of a stronger US dollar, exporters are less willing to settle forex transactions. Since late April, driven by the rapid depreciation of the yen, the US dollar index has once again surged above 103, hitting a new high in two decades.
However, the backdrop of the RMB depreciation should also be noted?—in the past year or so, the exchange rate of the RMB against the CFETS (China Foreign Exchange Trade System) currency basket has been climbing. Before this round of depreciation, the RMB to USD exchange rate was relatively stable, with a slight appreciation of 2.5% from the beginning of 2021 to April 18, 2022, but both currencies appreciated against many other currencies, so the value of RMB against the CFETS currency basket over the same period has risen by more than 12%.
Recently, the RMB has weakened sharply against the dollar but remained relatively stable against the basket of currencies. Therefore, we need to take all things into account instead of only focusing on the changes in the RMB/USD exchange rate.
Q: Based on the current pace of Fed tightening, there is room for further inversion of the interest rate spread between China and the US. How will it affect the exchange rate of RMB and capital flows? To what extent is the recent volatility in China’s stock market related to the narrowing interest rate spread between China and the US and the exchange rate swings?
Wang: Overall, the domestic market is mainly affected by domestic economic conditions and policies and much less so by the external environment. This is because in China’s bond and stock markets, foreign capital only accounts for a small share of around 3-4%. Besides, the stock market hasn’t seen a significant outflow of foreign capital recently. The bond market has seen some capital outflows due to rising interest rates overseas and expectations of RMB depreciation, but these are just short-term moves driven by the need of individual investors to adjust asset allocation or hedge risks.
Domestically, the repeated and scattered outbreaks of Covid-19 and some unexpected factors have put downward pressure on the economy, thus affecting market confidence. I think the recent market volatility is more related to these domestic factors.
Q: Since mid-March, the expectation of a weaker RMB against the dollar has seemed to be increasing. Do you think RMB will fall into a depreciation cycle?
Wang: So far, the RMB exchange rate against the CFETS currency basket is still above the level at the beginning of the year. Looking further back, the current exchange rate is 11% higher than that in early 2021, and 15%-16% higher than that in late 2019 and early 2020. If we assume that other exchange rates remain the same, the drop of RMB to 6.9 against the US dollar will only bring the CFETS RMB index back to 100.4, the average level in 2021. Therefore, the current pullback of the RMB against the US dollar is well within the normal fluctuations of the exchange rate.
After the outbreak of Covid-19 in 2020, China’s economy was among the first to recover; strong exports had kept China’s current account surplus at a relatively high level; and China’s government bond yields were higher than those in other countries. These three factors had bolstered the value of RMB since the second half of 2020. However, since Q4 2021, China’s economy has come under significant downward pressure, and the fundamentals that supported a strong RMB have started to weaken recently. As for whether the RMB will fall into a new round of depreciation against the US dollar, if the US dollar index continues to rise, the RMB may head for more losses as more market entities would start to hedge against the risk of RMB depreciation. But whether the RMB will continue to weaken remains to be seen because we also need to look at fluctuations in the US dollar against other currencies. For example, the Japanese yen has fallen to a 20-year low against the US dollar and there is little room for the yen to further weaken and drive the dollar index up.
The next thing to look at is the impact of the economic situation in China and the US on market confidence. If the pandemic can be controlled in China and the economy grows steadily while the US economy is affected by the Fed’s tightening policy, investors at home and abroad will gradually restore confidence in China’s market, and the RMB exchange rate will remain stable without going through a one-way depreciation.
In general, we expect the RMB to weaken further against the dollar in the coming months and even breach the critical level of 7. In the second half of 2022, as economic growth stabilizes and rebounds, market confidence will gradually resume, which could possibly send the RMB exchange rate back below 7 at the year end. We predict that in 2023, the US dollar will weaken against other major currencies while China’s economy will further recover, which will slightly push the RMB up to 6.7 per US dollar.
Q: Will exchange rate volatility constrain China’s monetary policy?
Wang: China has always maintained high autonomy of its monetary policy to serve its own needs. As China’s economy is facing downward pressure, monetary policy should be prudent yet slightly loose, which is the opposite of the Fed’s policy direction.
Meanwhile, as inflation in China is not very high, there is no need to worry too much about the impact of the RMB depreciation on inflation. Though RMB depreciation will put upward pressure on PPI, not much of which will be passed onto CPI given low food prices and weak end-user demand, so CPI should continue to be moderate. We expect that CPI will bounce back in the second half of 2022, but the annual average would be 2.4%.
On the other hand, the RMB exchange rate has appreciated a lot over the last year or so. In fact, there has been some overvaluation. Now it is adjusted in line with the market condition, and in a sense, the depreciation can also align with domestic monetary policy, which is not necessarily a bad thing. A slight depreciation of the RMB is in the same direction as monetary easing. The two can boost external and domestic demand, thereby increasing the aggregate demand and further bolstering the economy. Therefore, I think the current exchange rate volatility would not constrain the implementation of China’s monetary policy.
II. MORE GROWTH STABILIZATION POLICY WILL BE ROLLED OUT AGAINST PANDEMIC IMPACT IN APRIL
Q: How to assess the coronavirus shock on China’s economy in April?
Wang: The impact of the pandemic on the economy was significant in April. The manufacturing PMI data released by the National Bureau of Statistics and Caixin both fell sharply in April, indicating a significant decline of industrial production momentum. In April, the operating rate of blast furnace in Tangshan steel mills rebounded seasonally to 53%, five percentage points higher than the same period last year. The national average operating rate of electric arc furnace (EAF) was 65%, seven percentage points lower than the same period last year. The year-on-year decline in crude steel production in the first 20 days of April narrowed to 5%. The pandemic dealt a larger blow to industrial production in April than that in March through disruptions in logistics and supply chains. The index of road freight traffic fell by 27% year on year in April.
Retail sales of passenger cars fell sharply by 39% year on year in the first four weeks of April (down 15% year on year in March), while wholesale sales fell by 50% year on year. The average daily passenger volume of subways in ten major cities fell by 45% in April.
In terms of real estate, high-frequency data show that despite the recent policy adjustments, real estate sales in 30 major cities fell further by 54% year on year in April (down 47% year on year in March) due to the impact of the pandemic and the sluggish market demand. The land market was depressed in April as well, with the average premium rate of land transaction of 100 large- and medium-sized cities remaining at a low level of 2-3%, and the land transaction volume down by 32% year on year (previously, it was down 38% year on year).
We expect that the year-on-year growth rate of infrastructure investment in April may further rebound by 12%-15% with the support of public funds and an early start of some public projects. China issued local government special bonds of 1.3 trillion yuan in the first quarter of the year, and another 100 billion yuan in April. Recently, the central government also reiterated its support for infrastructure investment. We also expect the year-on-year growth of manufacturing investment to further slow to around 5%. Taking into account the year-on-year decline in real estate investment, we expect that the year-on-year growth rate of overall fixed asset investment may fall to around 3.5% in April from 7.1% in March, with a year-to-date growth of 7.2% year on year.
In terms of exports, the latest data released by the General Administration of Customs on May 9 showed that export in April was 273.62 billion US dollars, a year-on-year growth of 3.9%, down 10.8 percentage points from March. That's because the disruptions to logistics, transportation and production from Covid control measures were far more severe in April than in March, dragging down April's trade data. In addition, whether it is the overall growth rate or the growth rate of imports and exports, the data in the first four months of this year have declined compared with that of the first quarter; the PMI for new export orders released by the National Bureau of Statistics dropped sharply in April, while the average PMI of advanced economies in March and April also weakened. In the first 20 days of April, the year-on-year growth rate of container throughput at the eight major ports fell to zero, while March recorded a 6% year-on-year growth. In April, the average daily container throughput of the Port of Shanghai fell by about 19% year on year, the reason behind the smaller-than-expected fall was that more container transportation was shifted from land to water transport.
High-frequency data show weaker average producer prices, with thermal coal prices down 19% month on month in April, while rebar price edged up 2% month on month. Based on this, the month-on-month growth of PPI may slow down in April, and the year-on-year growth rate may decline to 7.1% under the high base effect. Meanwhile, the sluggish growth of service prices under the impact of the pandemic may drag down the growth momentum of non-food CPI. High-frequency data show that average food prices rebounded month on month, and pork price rose 2% month on month (down 43% year on year), vegetable price 2%, and fruit price 6%. Overall, the year-on-year growth rate of the overall CPI may increase slightly to 1.6%.
Q: How do you think macro policy should work in the next phase?
Wang: The CPC Politburo meeting held on April 29 pointed out that the resurgence of the pandemic and the Ukraine crisis have led to increased risks and challenges. It proposed to speed up the planning of expansionary policy tools and intensify well-timed controls, while accelerating the implementation of policies that have already been introduced. It is expected that more policy for stabilizing growth will be rolled out in the future.
First, infrastructure investment is an important element for stabilizing growth. The Central Financial and Economic Affairs Commission convened on April 26 to discuss the issue of comprehensively increasing infrastructure investment, and emphasized that infrastructure investment is an important support for economic and social development. At present, all the special bond quotas for infrastructure projects have been issued. It is necessary to speed up spending, strengthen fund management, and ensure that the special bonds will actually increase the scale of investment. Projects can cover electricity, new energy, and new infrastructure. The management and control of local financing platforms is recommended to be moderately relaxed so as to supplement the supporting funds required for infrastructure investment. On top of this, if the government can speed up the approval procedures and make full use of the funds transferred in and carried forward, the scale of additional financial support can reach 1% of GDP, which is expected to support the growth of infrastructure investment to more than 8% this year.
Second, monetary and credit policies will likely continue to be loosened. Given the recent move of the People's Bank of China to cut RRR for all banks in addition to a slew of special reloan instruments that have already been introduced, we believe that credit growth will rebound in the coming future. The growth of social financing is expected to reach a level around 11% by May and June, and average at 10% and above for the whole year.
Third, real estate policy could experience further adjustments. Since the end of last year, local governments have introduced measures to bolster up the real estate market, including relaxing house purchase restrictions, reducing the mortgage rate and down payments, and stepping up building public rental houses, affordable rental houses and houses with common property rights. The most recent Politburo meeting also called for intensified efforts in meeting genuine housing demand and the need for upgrades as well as enhancing regulation of house presales funds, which will help stabilize market sentiment and improve developers’ cash flows. We expect house sales and the space of newly constructed homes (seasonally adjusted) to bottom out and start to pick up at the end of Q2.
Financial data for Q1 show a sustained lack of financing demand from the real economy, owing to pressures on orders and cash flows as well as weakened confidence of businesses. We need to address both problems. Stimulating the need for infrastructure or houses could bring more orders and cash flows to businesses, but mostly to upstream heavy industries, which makes it different from consumption boosting policies that could revive downstream sectors especially the service sector.
I believe the top priority now remains to be striking a proper balance between Covid control and socio-economic development in order to boost market confidence. We must take more efficient, targeted and reasonable measures to contain the spread of the pandemic to enable orderly recovery of the economy and normal life. The meeting of the Politburo Standing Committee on May 5 also called for improved Covid control, intensified research and prevention of new variants, and increased vaccination, while cautioning against any one-size-fits-all approach.
Generally speaking, the Politburo meeting on April 29 has released positive signals, which, together with greater policy support going forward, will curb downward risks on China’s economic growth this year.
Q: How to boost consumption demand at the moment?
Wang: Consumer spending has remained sluggish because of two reasons: 1) Covid resurgences have dealt direct blows to high-contact spending activities; and 2) the labor market has been lackluster, putting a drag on household income growth with certain groups being especially vulnerable.
In order to stimulate demand, first, we need to control the spread of Covid in a more targeted and reasonable way. Second, provide small- and medium-sized enterprises (SMEs) with rental and electricity bill discounts, allow loan repayment deferrals as appropriate, further cut taxes and fees, reduce their contribution to social security programs such as the unemployment insurance, and step up employment subsidies. The problem is that under the current circumstances, it could take a rather long time for tax and fee cuts for businesses to translate into increased household spending, because the first thing that SMEs struggling for survival do with the benefits is to find ways to save more instead of spending the money saved. Third, given the time it takes for business subsidies to work in boosting demand, some of the local governments could turn to direct issuance of coupons, which might as well target only middle- and low-income groups and the most battered people during the pandemic.
III. RISK OF RECESSION IN THE EUROZONE DESERVES MORE ATTENTION THAN THAT IN THE US
Q: Interest rate spread inversion between China and the United States has rarely been accompanied by the inversion of the US bond yield curve in history. The latter has usually heralded recessions. Do you see the same happening this time? Is the US economy and the global economy facing the risk of recession?
Wang: We’d better look at the US economy and the global economy separately.
In terms of the US economy, in history, recession usually happened in the 5th or 6th quarter after the inversion of the yield curve where the two-year Treasury yields rose above the ten-year yields. But I don’t think looking at the history alone is enough, as we need to understand the causes of the high inflation and the inversion. Many consider the massive stimulus and the consequent economic overheat to be the culprits for inflation, but as a matter of fact, supply bottlenecks so far have played a bigger role, such as the supply chain disruptions amid the pandemic and the energy price hike as a result of the Ukraine crisis. These factors will evolve over time, and don’t have much to do with monetary policy.
According to the UBS, the Fed will step up monetary tightening, but will not carry it too far, and so a recession in the US is not very likely in the upcoming two years. The inversion of the Treasury bond yield curve to some extent shows that the market does not worry about sustained high inflation, rather than a prolonged recession.
In terms of the global economy, the Eurozone actually faces much higher risks of recession. The Ukraine crisis has dealt a huge blow to its supply given its high reliance on energy from Russia. Going forward, if Russia cuts off its energy supply to Europe or if Europe imposes further sanctions, the recession risk will rise significantly.
Q: If the Ukraine crisis persists and drags the Eurozone into a recession, how will it affect China?
Wang: It will mainly impact China by reshaping the global economy especially the European economy. The European Union is China’s biggest market for export. Its recession will undoubtedly negatively affect China’s export.
Second, should the global energy price stay high, it will inflict imported inflation pressure on China, a major energy importer and the world’s biggest oil importer, and push up the domestic price of energy and chemical products. This year, China has had rather high PPI growth and sluggish consumption. As a result, it’s very hard for raw material prices to pass on to the consumers, which will push up production costs.
Third, the Ukraine crisis has exacerbated global geopolitical risks and future investment uncertainties, and that will indirectly shock the Chinese market as well, shaking the confidence of investors at home and abroad.
This article is compiled based on an interview with Wang Tao, first published in CF40’s WeChat blog on May 9, 2022. It is translated by CF40 and has not been reviewed by the author. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
