Abstract: Experts at the January seminar of the CF40 Youth Forum believe that strong exports and settlement surpluses have been propelling the RMB exchange rate. Despite the fact that yuan is rising in value, there are no obvious unilateral expectations or overshooting risks.
I. STRUCTURAL FACTORS DRIVE POST-PANDEMIC RMB APPRECIATION; UNILATERAL EXPECTATIONS AND OVERSHOOTING RISKS HAVE NOT YET BEEN SEEN IN FOREIGN EXCHANGE MARKET
In 2021, Chinese yuan experienced a rare co-occurring appreciation with the US dollar, owing to structural factors. Despite a strong US dollar last year, the CNY/USD exchange rate went up by 2%, with the CFETS RMB Index nearing an all-time high. Experts at the seminar pointed out that the RMB exchange rate surge since last September has been driven primarily by supply and demand in order-to-order transactions, rather than external markets or the counter-cyclical factor.
The structural drivers can be summarized into three:
1. Strong exports and settlement surpluses are the main reason behind RMB appreciation. On the supply side, China was less constrained by the pandemic in 2021, compared with the US and Europe, which suffered from "labour shortages", and Southeast Asia, where factories had to shut down. China’s strong exports have driven up demand for forex settlement, rewriting the supply and demand relationship in the forex market.
2. Net inflow of direct investment and portfolio investment boost the RMB. Because of increased financial openness, China's financial account wields more power. The effectiveness of China's COVID policy increased foreign investor confidence, awarded with net inflows of direct and cross-border portfolio investment.
3. Diminished pessimism over US-China relation has had an indirect positive impact on RMB. In 2021, the RMB exchange rate received indirect support from frequent signals of improved US-China relations and improved risk sentiment in the capital markets.
4. Yuan's hedging properties have been enhanced. Following the outbreak of COVID-19, RMB exchange rate becomes the target of long speculation due to its low volatility, large spreads, and clear trends, bolstering the RMB exchange rate.
There hasn’t been sufficient evidence to suggest that the RMB is subject to significant unilateral expectations. In general, when the RMB is expected to depreciate, importers tend to accelerate forex purchases to reduce exchange costs, while exporters delay forex settlement. For example, during the 2015 exchange reform, China's import payment rate frequently exceeded 100%, and the deviation between it and the export settlement rate was once close to 90%, a situation not seen now. Since the outbreak, China's import payment rate has stabilized within a narrow range of 60-80%, and the deviation has remained at around 20%, reflecting no significant expectations of appreciation or depreciation from foreign-related corporates. Furthermore, when there are clear unilateral expectations, exchange rate volatility tends to rise. In contrast, the volatility of the RMB exchange rate has remained largely stable since the pandemic, with a trading band of 3.6% in 2021, smaller than the 7.5% annual average in the pre-pandemic three years. It’s safe to say that market expectations are stable in the absence of a systemic preference.
The current RMB exchange rate reflects actual supply and demand without deviating from or overshooting its fair value.
On the one hand, CNY/USD central parity rate has remained consistent with changes in the interest rate spread. As the spread remains the main factor in exchange rate movements, and the CNY/USD exchange rate is highly related to the spread bwtween10-year US and China government bonds, it can be used to decide whether the RMB exchange rate is desired. Prior to the pandemic, the CNY/USD exchange rate was dampened by trade war sentiment and never reached a level agreeable to the spread. After the outbreak, market sentiment has been boosted as China took the lead in resuming work and production. The 10-year US-China treasury yield spread is about 137 basis points, corresponding to a central parity rate at 6.37-6.38. Since mid-December 2021, the real central parity rate has remained between 6.36 to 6.39 with slight fluctuations, which matches the US-China spread.
On the other hand, the RMB's effective exchange rate is largely consistent with trade pricing. The CFETS RMB Index is priced by a basket of currencies whose weights are determined by each economy's trade weights with China, fully reflecting the RMB's actual demand and exchange value in international trade. Unlike in 2013 and 2015, when China's share of global exports is declining sharply but the CFETS index remains high with a clear tendency to overshoot, during the pandemic, China's export share increased significantly, with the corresponding basket of currency indices currently hovering around 100, not far from the 102 seen since December 2021. Overall, the current RMB exchange rate reflects current supply and demand as well as fair value.
II. RMB EXCHANGE RATE AND CROSS-BORDER CAPITAL FLOW ARE UNDER SHORT-TERM BUT CONTROLLABLE PRESSURE.
Many experts at the seminar believe that the surplus advantage that has supported the RMB's post-pandemic appreciation and massive capital inflows is fading, while a stronger US dollar and a misalignment of the US-China policy cycle will result in a slight weakening of the RMB and a tendency for cross-border capital outflows in the short term.
1. Exports are dwindling. On the demand side, importers, notably in the US, are reducing their demand, adding to the potential of an export slowdown in 22H1 in China. For one thing, developed economies are turning hawkish, cooling demand; for another, two-thirds of China’s newly added exports after the pandemic are driven by temporary demand, which is bound to stabilize, if not fall back down, in the medium or long term. On the supply side, recovery of the global supply chain is a downside to China’s export. The recovery in Southeast Asia, in particular, will divert some of China’s export orders.
2. The short-term strengthening of the US dollar and the narrowing of the interest rate gap between China and the United States will put downward pressure on the RMB exchange rate. The US dollar is an important benchmark with a traction force for the RMB. In the short term, with the gradual supply chain recovery of the auto industry, the need for inventory replenishment in the real estate sector, and the continuous release of consumption momentum brought about by excess savings, the US economy and the US dollar will see a trend of strengthening. In particular, as inflation expectations continue to rise, the Federal Reserve has released a signal to raise interest rates ahead of schedule, so the interest rate gap between the two countries will continue to narrow, which will place the RMB exchange rate under pressure in the short term.
3. The misalignment of policy cycles between China and other countries will impose pressure of capital outflows and weakening exchange rates. From the perspective of asset allocation, China has not only dislocated its policy cycle with that of the developed countries, but also showed a tendency to diverge in monetary policy with emerging economies. South Korea, Malaysia, India and other Asian countries have released obvious signals of tightening or interest rate hikes, and India's economy has achieved more-than-expected growth. These factors will drive overseas investors to reassess and adjust country weights in asset allocation. This in turn will increase pressure on China’s cross-border capital flows and the RMB exchange rate.
Experts also pointed out that despite the relatively high probability of short-term depreciation, the existence of supporting factors such as the high level of unsettled forex settlement surplus, the limited impact of China-US interest rate differentials, and the increasing demand for diversified allocation of global capital will somehow offset the adverse effects of RMB depreciation and capital outflow. Overall, the depreciation of the RMB exchange rate in the next stage will not be very sharp and the risk of capital outflows is controllable.
First, the strengthening of foreign exchange settlement under trade will support the RMB exchange rate. After the outbreak of the Covid pandemic, the RMB has continued to appreciate, so exporters and banks have been less willing to settle foreign exchange proceeds. China’s high trade surplus has not been fully transformed into a high forex settlement surplus. According to estimates, the scale of unsettled forex surplus is as high as 500-600 billion US dollars. Therefore, as the RMB sees appreciation slow down or even starts to depreciate, companies will have rising willingness to settle foreign exchange, which will help support the strengthening of RMB. In addition, experts also pointed out two possibilities that may help keep China’s advantage of trade surplus. First, the uncertainty of the pandemic in the rest of the world will delay the recovery of the global supply chain. In particular, the pandemic management and economic recovery of emerging economies are still facing great resistance, so they have rather limited impact on changes in China’s export share. Second, tensions of China-US trade relations will further ease. Although in the context of the US mid-term elections, there is low possibility for the United States to reduce tariffs in an all-round way, it is still possible for it to increase the tariff exclusion ratio, thereby increasing China’s potential export level.
Second, the narrowing of the interest rate gap between China and the United States may have a limited impact on China’s foreign exchange market and the RMB exchange rate. Experts pointed out that, in developed countries, the trend of financial accounts depends on securities and portfolio investment, and the foreign exchange market is highly sensitive to China-US interest rate differentials. However, different from developed countries, the volatility of China’s financial account is mainly reflected in "other investments", with driving factors like the exchange rate expectations of foreign-related enterprises, foreign exchange settlement and sales, receipt and payment, and cross-border financing. Although changes in the interest rate spread between China and the United States will also magnify exchange rate fluctuations through cross-border securities investment, domestic economic fundamentals and business confidence have a more decisive impact on the foreign exchange market. Some experts said that the conversion of old and new kinetic energy and the adjustment of economic structure in China may boost the level of total factor productivity, so the RMB exchange rate still has rather resilient fundamental support. In the United States, overdraft by the federal government during the pandemic has led to impaired credit, so there is a high probability for the dollar to weaken in the medium and long term. In addition, experts pointed out that there are still uncertainties in the forward guidance and implementation of the three interest rate hikes in 2022, and it is still difficult to determine its substantial impact on the trend of the US dollar and global capital flows.
Third, the demand for diversified allocation drives foreign countries to increase holdings of RMB assets, which may offset the restraining effect of the reduced interest rate gap. Although the narrowed interest rate differential can inhibit the motivation of overseas investors to increase their holdings of RMB assets, foreign investors, including global central banks and monetary authorities, have achieved a structural increase in RMB assets due to the consideration of realizing diversified allocation. In recent years, the RMB's international status and asset attractiveness have increased significantly, but its share in global foreign exchange reserves is only about 3%. Under the expectation that the US dollar will weaken in the medium and long term, the global monetary authorities have a strong motive to increase their holdings of RMB assets, and their potential demand will far exceed that of the private sector, thereby supporting the RMB exchange rate.
III. POLICY SUGGESTIONS
First, macro control should be aimed at boosting domestic fundamentals and market confidence. As mentioned above, even in the prospect of US interest rate hikes and overseas market volatility, as long as the domestic fundamentals remain stable, the pressure on both the RMB exchange rate and cross-border capital flows are limited and controllable. Experts pointed out that although the narrowing of the interest rate gap between China and the United States will put some downward pressure on the RMB exchange rate, given that economic fundamentals have a decisive impact on the trend of the foreign exchange market, more active fiscal and monetary policies should be adopted in the next stage to boost domestic economic sentiment and business confidence.
Second, further enhance the flexibility of the exchange rate to avoid unilateral expectations in the foreign exchange market. The flexibility of the RMB exchange rate has been significantly improved in recent years, enabling market clearing in a timely manner, and breaking the unilateral expectation of the exchange rate trend. It brings positive effect in two ways. For one thing, it can effectively prevent cross-border capital flows from forming a herd effect fueled by speculative capital. For another, it can effectively avoid the large fluctuations in the foreign exchange market caused by the release of unilateral expectations. Therefore, we should continue to maintain the high flexibility of the RMB exchange rate to buffer external shocks and avoid systemic risks. Monetary policy should be allowed to play its role of counter-cyclical adjustment.
Third, continue to promote institutional improvement such as capital account reform, and further improve the pricing power of the RMB exchange rate. Market experts pointed out that although China’s economic fundamentals weakened in 2021, the RMB still appreciated with lower volatility. To a large extent, China is still prudent in the management of the capital account, and the pressure on capital outflows has not been fully met. In the next step, we should actively promote in-depth discussions on the principles for foreign exchange transactions, capital account liberalization and other institutional reform issues, so as to lay a solid market foundation for the further improvement of the RMB exchange rate mechanism.
This article is the outcome of a closed-door seminar organized by CF40, compiled by Research Associate Yang Minyue.
