Abstract: Following Federal Reserve Chairman Jerome Powell's hawkish speech in Jackson Hole on August 26, non-dollar currencies tumbled as the CNY dropped below 6.91 against the dollar, pushing the US dollar index to a new 20-year high. How long will the dollar's strength persist? What will happen to the RMB's exchange rate and those of other non-USD currencies? Will the yuan's depreciation limit China's monetary policy? What is the likelihood that the US economy will experience a severe recession? How ought China to react?
Q: Please provide a brief analysis of the causes for and trends in the present strong USD as well as your predictions for the currency's trajectory from the second half of this year through the end of next year.
Xu Gao: The supporting factors behind the strengthening of the US dollar can be seen from the short and medium term. Powell's "hawkish" speech is supporting the dollar in the short term, but the medium-term element is of more significance. The Federal Reserve's ultra-easy monetary policy contributed to a demand-pull inflation after the COVID-19 pandemic broke out. To hit its 2% inflation target, the Fed had to restrain the growth of aggregate demand through monetary tightening. As a result, the Fed has begun a cycle of tightening monetary policy since the second part of last year. Whether it is doing so by hiking or tapering, the policies are quite aggressive. Other nations are also tightening their monetary policy but not as drastic as the U.S., and that strengthens the dollar.
The Fed must tighten monetary policy to control high inflation. The dollar will remain strong in the second half of this year given the persistent inflationary pressures. However, the rate of U.S. economic growth has slowed down recently, and a recession is now more likely. Inflation is anticipated to progressively decrease. Therefore, I think the dollar is at its peak from a long-term perspective, albeit this does not rule out another new high in the future.
Yi Huan: The strong dollar exchange rate is fundamentally driven by the short supply of dollar. The key drivers include, specifically, improved U.S. trade, rising global safe-haven demand, and tighter dollar liquidity. Looking ahead, the Fed’s doubled rate of tapering and slowing domestic demand growth could amplify the pressure on global dollar reach its highest point this winter and next spring, but with the downward adjustment of U.S. growth expectations and the increase in the frequency of interest rate hikes by other central banks, the dollar index may peak and fall.
Zhang Yu: It is expected that the US dollar will hold its value from the end of this year to the beginning of next year, that is, before the Fed's rate hike formally comes to an end. By the end of next year, it is expected that the US dollar will show a state of strengthening before weakening, depending on how the state of the global economy changes as a result of this round of interest rate hikes. In a risk-off mindset, it might also persist longer.
Q: What do you think of the RMB's tendency given the strong dollar? Is there a range of acceptable RMB exchange rate fluctuations? Will the future monetary policy options available to China’s central bank be restricted by the depreciation of the RMB?
Xu Gao: The strong dollar will last for a while in the second half of the year. At the same time, China's exports are probably no longer growing at their fastest rate, and may shrink compared to the first half of the year. The RMB is therefore anticipated to maintain its trend in the second half of the year, but this depreciation would be light, orderly, and manageable.
I think it is critical that the renminbi avoid panic or unruly depreciation in order to determine whether it trades within a desirable range. The central bank is likely to stay out of the market if the renminbi depreciates in an orderly and controlled manner, as it is doing right now. The RMB will inevitably face devaluation pressure if China's monetary policy is left lax in response to the Fed's move. On the domestic monetary policy, it exerted some discipline, but at the time, this restraint is not very strong.
Yi Huan: In the short term, the RMB may be under pressure, mainly because the dollar may continue to soar; in the medium and long term, the real exchange rate of the RMB is more resilient, because the real exchange rate movement ultimately depends on the real economy and changes in the marginal return on investment of financial assets. If the RMB maintains a stable trend against a basket of currencies, the fluctuation of the RMB exchange rate can be regarded as part of the monetary policy adjustment tool, that is to say, it is completely reasonable for the RMB exchange rate to fluctuate appropriately against the dollar in such an environment. In this case, the central bank may not directly intervene in the RMB exchange rate trend. Therefore, the impact of exchange rate depreciation on the central bank's monetary policy may be limited.
Zhang Yu: The exchange rate price is determined by the macroeconomic fundamentals and the current state of transactions. There is no predetermined value, and it is impossible to predict the so-called desirable range in advance. In fact, how can there be unilateral expectations if the exchange rate varies sufficiently? Unilateral expectations do not come out of fluctuations. When market forces lead the devaluation, forcible prevention will promote unilateral expectations. Therefore, in the follow-up exchange rate fluctuations, the regulators should continue to liberalize the exchange rate flexibility, albeit allowing sufficient trading period upon some important levels to control the risk and the speed of decline, instead of changing the direction or the amplitude.
As for whether the exchange rate will constrain monetary policy, the central bank has made it clear through interest rate cut: first, the monetary policy is dominated by China’s own reality; second, inflation is still not the core problem, and the policy tends to be loose. In other words, in the "Impossible Triangle", the central bank has given a higher priority to the independence of monetary policy. In a sense, since the interest rate is cut at the current time point, it actually means that the exchange rate will remain more flexible, that is, the exchange rate will be handed over to the market, and the flexibility of the exchange rate will be used to ensure better independence of monetary policy.
Q: The RMB has remained relatively strong and stable compared to other non-USD currencies in 2022. What is your view on this phenomenon?
Xu: From the second half of last year to the present, the RMB has shown very strong resilience. In comparison, the current US dollar index is far higher than the high point of the cycle in 2019. At that time, the RMB depreciated against US dollar to above 7.1, but now the depreciation of RMB has not yet reached that level. This comparison shows the high resilience of RMB, which is mainly due to the support of exports. After the outbreak of the pandemic, the expansion of global demand has boosted China's exports, which has led to the increase of China's trade surplus and the accumulation of foreign exchange in the private sector. The foreign exchange balance of the residential and corporate sector is at its best time in more than a decade.
Q: What are your expectations for the pace and magnitude of Fed’s rate hikes and balance sheet reductions by the end of this year and next year? Will 4% be the end of this round of rate hikes? How do you see the probability of the US economy falling into a substantial recession and what are the features of the economy?
Xu Gao: It's hard to predict now that 4% is the "end point" for US rate hikes. From the dot plot released by the Fed, interest rates may end up at 4%, but 4% may not be the peak of this round of rate hikes. After the outbreak of the pandemic, the Fed substantially loosened its monetary policy, which resulted in unprecedented demand expansion. In this case, whether the 4% interest rate can bring the highest inflation level in the 40 years under control is yet unclear. To make the judgment requires further observation. It’s of high probability that the Fed will raise interest rates by 75 basis points in September. The US monetary tightening process is probably far from over, and this will also exert downward pressure on the US economy. A substantial recession in the US economy will be a high probability event. Judging from the GDP data, the US economy has shrunk for two consecutive quarters, and the economy has technically fallen into a recession. It still faces huge challenges in the second half of this year.
Yi Huan: Under the benchmark scenario, the Fed is expected to raise interest rates by 50, 25, and 25 basis points in September, November and December this year. Whether or not to raise interest rates next year will depend on changes in US financial conditions. If US financial conditions improve due to rosy stock markets and consequently push up inflation expectations, the Fed may continue its efforts to raise interest rates next year. There is no probability for the Fed to cut interest rates before the end of next year. Under the circumstance that US inflation does not significantly exceed expectations, 3.5-4% may be the end point of this round of interest rate hikes.
It is worth noting that, the Fed may shrink its balance sheet by $95 billion per month as planned starting from this September. It is expected that the US dollar liquidity crunch may intensify after September, and the tail risk of the global financial system will rise. The Fed may suspend its balance sheet reduction efforts in the face of the rising probability of an economic recession. The US economy is expected to have a more than 50% chance of falling into a substantial recession by the end of next year. If recession really happens in 2023, the process of economic repairing will be more difficult, and the economy will stay in the low or even negative growth territory for longer.
Zhang Yu: The end point of the Fed rate hikes will definitely be above 3.5%, and whether it can reach 4% or even higher depends on the future evolvement of inflation. There may be three more rate hikes this year, one or two of which may exceed expectations. Two characteristics will be seen in terms of US economic recession. One is that the recession will be a cyclical recession rather than a crisis; the other is that it will be a short-term recession rather than an enduring one. The US economy is highly resilient. The government, residential, and corporate sectors have all remained rather healthy, and no sector is faced with a major crisis. This means that once the monetary policy is shifted to a loose one, the US economy will easily set foot on a normal recovery track.
Q: How will subsequent changes in US dollar liquidity and the risk of a US recession affect global financial markets? How should China’s macro policies and investors respond?
Xu Gao: For global financial markets, the US interest rate hike and balance sheet reduction mean a contraction in global liquidity. In the past two years, the extremely loose monetary policy of the United States has pushed up the valuation of various financial assets such as US stocks. In the current context of strong monetary tightening, the highly valued assets are likely to face greater pressure for adjustment and higher risks. For China, the economy is currently facing greater downward pressure, but the pressure mainly comes from domestic factors. China must stabilize domestic aggregate demand as soon as possible and curb the continued weakening of domestic demand.
Yi Huan: There is a mutually reinforcing relationship between changes in US dollar liquidity and the risk of a global recession, especially with the negative feedback mechanism brought about by rising financial risks in emerging markets. Countries with deteriorating trade conditions and emerging markets with greater fiscal and external debt pressure will be more challenged, and face rising financial risks. Facing them are currency depreciation, increased pressure on debt repayment, and fragile equity markets. With the rising risk of global recession, China's external demand will see downward pressure, and the growth of export-related industries will be dragged down, which poses potential risks for domestic growth in the second half of the year. Therefore, China needs to further enhance the strength and effectiveness of its stabilization policy. In order to ensure sound growth of the domestic economy, real estate deleveraging and pandemic prevention and control measures require more effective policy support. Monetary policy should focus more on the stability of the financial system, while the China-US interest rate spread should not be a major concern in the policy formulation.
Zhang Yu: In the second half of the year, there are three major risks of special concern. First, if inflation in the US goes beyond expectations in the next six months, the Fed will continue its hawkish stance to strengthen rate hikes in order to curb inflation, which will be a very important external risk; second, instability of some emerging market countries and vulnerable countries in the Europe may pose risks; third, whether the Bank of Japan can maintain its yield curve control (YCC) policy will also make a difference. Moreover, we have to be especially cautious whether these risks will entangle with other risk events. For example, Europe is likely to encounter a more serious energy crisis when winter comes, and the conflict between Russia and Ukraine may intensify once more. At that time, we will see a more complex global situation and increased short-term or repeated risk-off trades around the globe due to strengthened risk aversion and liquidity tensions.
Q: How do you evaluate the risks and the resulting impacts of other non-US currencies such as the Japanese yen, euro, and South Korean won?
Yi Huan: The weakening of the yen and euro against the US dollar since this year is mainly caused by significantly worse trade conditions. Since Q2 2022, while China and other Southeast Asian countries have maintained a trade surplus among major manufacturing clusters, other economies like the EU, Japan, and South Korea have posted trade deficits due to their over-reliance on energy imports and the impacts of slower global demand growth. For Europe and Japan, their real overseas purchasing power in terms of US dollar is declining rapidly, but the tail risk is not large. In addition to worse trade conditions, the decreasing South Korean won against the US dollar might reflect the high level of South Korea’s external debt, and the impact of mounting financial risks in emerging markets. But in general, the won does not face substantial financial risks.
Zhang Yu: The issues behind the euro, yen, and won are different. The euro faces the question of whether Europe will encounter a huge crisis. Behind the yen is whether yield curve control (YCC) policy can be maintained when the BOJ’s policy heads in the opposite direction from the US and global monetary policies, and meanwhile Japan’s domestic inflation is rising. The won and yen are closely related, with similar movement and transaction logic, since both are export-oriented countries. If for some reason the yen collapses in the future, the won might also suffer the same fate.
As for the euro, it is more likely to witness a normal depreciation along with economic volatility or recession, whereas the risk of another huge European debt crisis is not high. First, the ratio of non-performing loans in European banks is low. Second, with years of quantitative easing, the ECB has purchased 30% of the sovereign debt from relatively less well-off European countries like Greece, Italy, and Spain, becoming the largest debt creditor of these countries. Hence the exposure of financial institutions in the eurozone is decreasing. In this sense, compared with the 2011 European debt crisis, 2014 Greece’s debt crisis, and 2016 European banks’ crisis, the bad loan ratio in European banks is lower and the ownership structure of sovereign debt of less well-off countries is better. The future of yen still depends on whether the BOJ can hold on to its yield curve control (YCC) policy in the game with international hot money. In my opinion, the pressure on the yen will not last for too long. As long as it survives the end of this round of US rate hikes early next year, the hardest time for the yen will be over. Indeed, the probability of further pressure on the yen in the next six months is still there.
