Abstract: Recent RMB exchange rate fluctuations reflect significant pressure on capital outflows caused by both internal and external factors, of which the two most important factors are economic performance and the exchange rate formation mechanism. Boosting economic performance is the best way to stabilize capital flows and the value of the Chinese yuan.
Ⅰ. BOTH INTERNAL AND EXTERNAL CAUSES ARE CONTRIBUTING TO INCREASED CAPITAL OUTFLOWS AND RMB DEPRECIATION.
The market has been concerned about the RMB's volatility since this April. The CFETS RMB index dropped from 105.08 to 100.41. USD/CNY quickly increased from 6.36 to 6.8, then settled at 6.6-6.7. These shifts are a result of cross-border capital flows, and the currency’s depreciation reflects the significant pressure on capital outflows. Capital outflows and RMB depreciation have recently been under pressure due to both internal and foreign forces.
In terms of external factors, the market expects the Fed to accelerate rate hikes and taper, which will worsen capital outflows from emerging economies. History shows that when the market expects the Fed to raise interest rates, capital tends to rush out of emerging economies. In response to severe inflationary pressures, hikes and tapering have been faster than market expectations since the beginning of this year, and both the U.S. stock and bond markets have witnessed sharp corrections.
Many international financial institutions anticipate speedier Fed rate hikes. As a result of this anticipation, foreign capital will withdraw from emerging economies and flow back to advanced economies. For example, when the Federal Reserve signaled to phase out its loose monetary policy and raise interest rates at the end of 2014, the market began to expect rate hikes, and many emerging economies, including China, saw net capital outflows. When the Fed officially hiked rates in 2016, however, China saw a dramatic reduction in net capital outflows and a gradual return to net capital inflows.
Internal reasons affecting capital flows include a shift in the market's expectation of the economic growth gap between China and the world, which is the most important reason currently affecting capital flows. Some big cities in China suffered economically from the Covid resurgence in Q2. Several macro indicators showed evident marginal falls in April. The Chinese economy is under pressure from contracting internal and overseas demand.
Market participants and investors' expectations for China's long-term economic growth are shifting as a result of the current economic environment. If market participants, particularly foreign investors, are concerned that the current downward pressure will persist, then foreign companies and financial institutions will suspend direct or financial investment in China, or reduce holdings of financial assets in China, which will lead to a decrease in capital inflows and an increase in capital outflows.
Ⅱ. THE MOST IMPORTANT FACTORS AFFECTING CAPITAL FLOWS ARE CHINA’S ECONOMIC PERFORMANCE AND THE EXCHANGE RATE FORMATION MECHANISM.
Given the many factors that affect capital flow and the complex influencing mechanisms, it's tough to pinpoint any change to a single factor. Rather, the changes are influenced by a combination of factors, of which the degree of domestic economic success and the RMB exchange rate formation mechanism are the two most notable influencing elements.
The reason why economic performance affects capital flows is related to the structure of market entities involved in capital flows. Companies with foreign trade and foreign investment backgrounds and companies in industries with limited domestic financing are the most important market participants, whose operating conditions and cash flow arrangements are highly correlated with economic prosperity. When the domestic economy prospers, these companies tend to keep their business in China, requiring more RMB assets and reducing USD liabilities, which brings capital inflows. On the contrary, when the domestic economy weakens, these companies favor overseas markets, increasing US dollar liabilities and reducing RMB assets, which leads to capital outflows.
The impact of the RMB exchange rate formation mechanism on capital flows is mainly reflected in the following: an inelastic exchange rate mechanism will bring about continuous unilateral appreciation or unilateral depreciation expectations, generating more speculative demand and expanding the volatility of cross-border capital flows. The current RMB exchange rate formation mechanism includes three basic elements – "based on market supply and demand", "referencing to a basket of currencies", and "kept at a reasonable and balanced level". However, the three elements frequently contradict one another, resulting in a lack of flexibility in the RMB exchange rate and making it difficult for the foreign exchange market to accomplish adequate market clearance. Over time, market participants will develop unilateral appreciation or depreciation expectations, creating more speculative demand and exacerbating volatility in cross-border capital flows.
China’s central bank withdrew from normalized foreign exchange intervention after 2007 and began to phase out the counter-cyclical factor in the exchange rate formation mechanism in 2020, a move that made the price of yuan more market-based and elastic, so expectations of unilateral appreciation or unilateral depreciation have become rarer.
Furthermore, the interest rate spreads between China and the United States have an impact on the RMB price, but this effect is neither consistent nor large. The spread could explain fluctuations in the RMB exchange rate in some cases, but more often than not, the explanatory power is limited. As a result, interest rate spread may not be the most important aspect for policymakers to consider.
Ⅲ. POLICY SUGGESTIONS
Cross-border capital flows deserve constant attention, especially the risk of large-scale capital outflows. Boosting the economy is the best way to stabilize capital flows and the RMB exchange rate. China should strike a good balance between internal and external factors, and focus efforts on boosting the domestic economy, so as to impress upon market players China's stable policy orientation and positive long-term economic prospects.
First, level up macroeconomic policies to stabilize aggregate demand and improve short-term economic performance. Through tools such as RRR cuts and interest rate cuts, monetary policy could provide sufficient liquidity to the market, reduce the debt cost and strengthen the balance sheet of the real economy. Fiscal policies should be more proactive and flexible. After completing the existing budget arrangements, a stronger fiscal stimulus plan should be timely launched with relief funds for the Covid-stricken enterprises and households to directly stimulate aggregate demand, especially consumer demand.
Second, maintain sufficient flexibility of the RMB exchange rate and weaken market expectations for central bank intervention. Maintaining the flexibility of the RMB exchange rate is an important basis for macro policy autonomy. The PBC should send the market clear policy signals, improve the transparency and marketization of the exchange rate formation mechanism, and give full play to the exchange rate as a macro buffer.
Third, pay close attention to changes in market expectations to prevent "herd effects" in the foreign exchange market. Improve cross-border capital supervision capabilities, build capacity for ex-ante and ex-post regulation, strengthen daily standardized management of short-term cross-border capital flows, increase responsiveness to sudden surges in cross-border capital flow and prevent related risks, pay heightened attention to capital outflows that are unregulated or unaccounted for, and gradually include capital outflows via informal channels into statistical and supervisory systems, so that the potential hazards can be handled as much as feasible.
This article is part of the CF40 briefing series, based on a seminar on "China's Economy and RMB Exchange Rate amid Global Financial Market Turbulence" held on May 22, 2022. The editor of this article is Zhu He, CF40 Research Fellow and Deputy Director of the CF40 Research Department.
