Abstract: Multiple internal and external factors contribute to the recent depreciation of the RMB. The monetary and credit policies may continue to relax in the next phase. The People’s Bank of China may cut interest rates again this year, still by ten basis points. In the short term, the widening bond spreads between China and US may put further depreciation pressure on the RMB exchange rate. But if the interest rate cut is reinforced by strong growth-stabilizing policies and thus promotes the steady growth of China’s economy, it will benefit the RMB exchange rate. For the time being, the People’s Bank of China doesn’t need to intervene in the exchange market directly, but to release a stable signal; the bank may take measures to stabilize the exchange rate expectations. The Federal Reserve will suspend rate hikes after July and may start rate cuts by the end of 2023. Meanwhile, China is expected to introduce policies to stabilize growth. In this case, the RMB is expected to rise below 7 against US dollar by the end of the year.
Since the beginning of May, the Renminbi has continued to dip against the United States Dollar (USD). After mid-June, the RMB exchange rate showed a rapid depreciation trend, with the offshore RMB once falling below 7.28.
How to view the recent rapid depreciation of the RMB exchange rate and its future trend has become one of the most important focuses of the market. In a recent interview with the CF40 Research Department, Wang Tao, CF40 guest researcher and UBS Securities chief China economist shared her understanding of related issues.
The following is the interview:
Q1: Since the beginning of the second quarter, the RMB has weakened significantly against the USD. In particular, its decline has sped up since the beginning of May. The RMB also depreciated against a basket of currencies. What factors are behind this?
Wang Tao: Since the beginning of the second quarter, the RMB has depreciated significantly against the USD for several reasons:
First, USD has appreciated slightly. Recently, the US economy has shown stronger resilience than the previous market expectation. Meanwhile, US domestic inflation has been more stubborn than previously expected. Therefore, the market expectation for the Fed to raise interest rates strengthens. Previously, many believed that the Fed was likely to suspend rate hikes in May this year. However, at present, the market generally expects that the Fed will raise interest rates once more this year, that after this rate hike, the federal benchmark rate may stay rather high for a longer period, and that the Fed will not immediately start cutting rates. Due to USD appreciation and rising expectations of a Fed rate hike, the dollar index strengthened.
Second, China’s economic recovery has slowed down. After April, especially after May, China’s economic recovery is under pressure. Meanwhile, export declined sharply in May, which is bound to pull down China’s trade surplus. As China’s economic recovery slows down, the market expects a more accommodative monetary policy, i.e., interest rate cuts by the People’s Bank of China, leading to divergence in monetary policy between China and the US, widening spreads between China and the US and more pressure on the RMB exchange rate.
Against this backdrop, international financial institutions adopt a wait-and-see approach toward China’s capital market. Recently China’s capital market has been giving a moderate performance, and foreign holdings in Chinese stocks and bonds have declined. Moreover, China has opened its door after the pandemic, and this will contribute to capital outflows. In all, the current cross-border capital flows harm the RMB exchange rate trend.
Q2: In the first quarter, China’s current account surplus was $82 billion, down from a year ago. Taking into account the changes in the domestic and international environment this year, how do you expect the trend of China’s current account surplus this year? How do you assess the impact of China’s cross-border capital flows on the RMB exchange rate?
Wang Tao: Overall, we conclude that China’s current account surplus will narrow this year for several specific reasons:
First, China’s exports may decline this year, partly because of the global economic slowdown. Meanwhile, in the current downward cycle, the contraction of global high-tech products may harm China’s exports.
Second, on the import, especially the service import side, as the cross-border people-to-people exchanges have resumed after the pandemic, China’s outbound travel has increased significantly. The widening tourism deficit pushes the service trade deficit to increase, leading to a narrowing current account surplus.
Taken together, China’s current account surplus is expected to decrease from about $400 billion in 2022 to about $300 billion in 2023.
Regarding the question about the cross-border capital flows in China, here is my understanding. As mentioned earlier, according to the performance of China’s capital market, our stock market has become more volatile, and the bond market has seen a decline in government bond yields while US government bond yields remain high. Under such circumstances, foreign capital inflows are decreasing, and cross-border capital outflows have increased.
Q3: How accommodative do you think China’s monetary policy will be in the next phase? How will it affect the future trend of the RMB exchange rate?
Wang Tao: Due to the slowdown in China’s economic recovery, the People’s Bank of China cut interest rates by ten basis points on June 13. The central bank is expected to cut interest rates once again, still by ten basis points. In all, China’s monetary and credit policies may be relaxed.
The impact of the interest rate cuts on the RMB exchange rate should be analyzed from two aspects:
In the short term, the market strengthens its expectation to ease China’s monetary policy, and China’s 10-year government bond yields may further go down from the already-low level while the US government bond yields remain high. Such a contrast will put depreciation pressure on the RMB exchange rate.
At the same time, if China’s monetary policy is accommodative enough, reinforced by strong growth stabilization policies, such as increasing fiscal spending and introducing policies to stabilize real estate, it will stabilize China’s economic growth and lead to recovery in the second half of the year. Such an accommodative monetary policy will become a pillar of the RMB exchange rate.
Therefore, it cannot be simply put that “interest rate cuts by the central bank will lead to the RMB exchange rate depreciation”. If the interest rate cut is reinforced by strong growth-stabilizing policies and thus promotes the steady growth of China’s economy, it will benefit the RMB exchange rate.
Q4: If the RMB continues to depreciate, does the People's Bank of China need to take measures to regulate the exchange rate? If so, what are the effective means to adjust the exchange rate?
Wang Tao: I think it depends on the goals set by the Chinese government and the People's Bank of China for the exchange rate level.
In terms of the current situation, the government and the People's Bank of China have gradually expanded the floating range of the RMB exchange rate, allowing short-term two-way fluctuations to some extent, and thus enhancing the flexibility of the exchange rate system. In light of various market factors and the influence of the US dollar's relative appreciation, the RMB to USD exchange rate has experienced certain depreciation.
Considering the prevailing economic climate, I think that direct interventions in the foreign exchange market by the People's Bank of China are not necessary. The RMB's depreciation against a basket of currencies remains relatively small — though depreciation is discernible relative to 2022's average level. The current RMB exchange rate still holds its ground when contrasted against 2021's average level.
However, if the People's Bank of China is worried about the rapid RMB depreciation and the potential unilateral depreciation expectations in the market, it may also take corresponding measures to stabilize the expected RMB exchange rate.
The toolkit for exchange rate adjustments is multifaceted. For example, an adjustment to the RMB to USD central parity rate is available. On June 27, the RMB to USD central parity rate was 7.2098, approximately 100 points stronger than general market predictions, seemingly broadcasting a message of stability from the People's Bank of China. This could be perceived as the central bank's strategic maneuvering. In addition, the People's Bank of China can also resort to other tactics, such as leveraging countercyclical adjustment factors or heightening oversight over cross-border capital flows.
Q5: What are your expectations for the trend of the RMB exchange rate in the second half of the year? Do you have specific forecasts for the exchange rate fluctuation range and the end-of-year exchange rate point? There are views suggesting that the domestic economic fundamentals have a far greater impact on China's foreign exchange market than interest rate differentials. What is your take on this? Can the China-US interest rate differential still serve as a leading indicator for the RMB exchange rate?
Wang Tao: I agree with the assertion that "the influence of domestic economic fundamentals on China's foreign exchange market considerably outweighs the impact of interest rate differentials". Given the current circumstances, I think this judgement is correct. In the long term, the comparative state of economic fundamentals between the two countries bears a more decisive influence on the exchange rate. Nevertheless, this does not preclude the China-US interest rate differential from currently serving as a leading indicator for the RMB exchange rate.
In the short term, the RMB exchange rate still faces depreciation pressures within the next one to two months. On the one hand, market expectations predict the Federal Reserve might continue to raise interest rates in July. On the other hand, China's economic recovery momentum is slowing down, and market expectations for China's monetary policy foresee further rate cuts. This divergence in expectations can exert depreciation pressure on the RMB exchange rate.
Looking further ahead, we predict the Federal Reserve will cease interest rate hikes after July, and by the end of 2023, it might commence rate cuts. US Treasury yields will correspondingly exhibit a downward trend. At the same time, we expect that the Chinese government will continue to roll out a series of policies to stabilize growth. The growth rate for the second half of the year will significantly outpace Q2's growth rate, indicating a clear stabilization and acceleration in recovery momentum, thereby achieving this year's 5% economic growth target. As China's economy rebounds in the second half of the year, Chinese Treasury yields will hit bottom and rebound. We expect that the yield on 10-year Chinese government bonds will reach a level of 2.7% - 2.8% by the end of the year.
Given the improvement of the Chinese economy and the cessation, or even reversal, of US rate hikes, we foresee the US dollar depreciating against other major currencies in the second half of this year, particularly in Q4. Considering that the Bank of Japan may start taking action within the year to adjust its ultra-loose monetary policy, the USD is likely to depreciate against the JPY. Additionally, we expect a slight appreciation of the Euro against the USD in the future.
Taking into account the aforementioned factors, we predict that the RMB may depreciate slightly against the USD in the second half of the year, but it will return to below 7 by the end of the year. Of course, the RMB's exchange rate will also depreciate slightly against a basket of currencies.
Q6: What are your suggestions for boosting market confidence and expectations for the RMB?
Wang Tao: The most crucial factor is to enhance market confidence and expectations for the economy by further increasing policies to stabilize growth. The domestic economic recovery encountered some obstacles in May and June this year. Currently, real estate construction data has returned to its lowest level at the end of 2022. Although sales outpace construction, the sales data also shows a significant slowdown. Meanwhile, the pace of consumer recovery is slowing, and exports face pressure. Under such circumstances, several macroeconomic policies have been rolled out. Besides the mid-month rate cut, the People's Bank of China decided at the end of June to increase the re-loan and re-discount quota by 200 billion yuan to further enhance financial support for agriculture, small and micro businesses, and private enterprises.
Looking ahead, I believe that a significant economic boost may require more potent measures to stabilize growth, particularly a more effective and vigorous fiscal policy. Currently, some businesses are in difficult operational conditions, and consumer confidence is relatively low. Overall, both corporate and consumer credit demand is weak, and fiscal policy often proves more effective in this case. For instance, accelerating the credit extension in policy banks and focusing on supporting and driving infrastructure construction are crucial. Also, strengthening funds support for "ensuring construction and delivery of properties" and stabilizing the real estate market are extremely important. In addition, it is possible to consider optimizing house purchase restrictions in second-tier cities and further reducing the down payment ratio for second homes.
This article is compiled based on an interview with Wang Tao, first published in CF40’s WeChat blog on July 4, 2023. 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.
