Beijing seen sticking to stable yuan following rate cut
Capital reform goals and the IMF's SDR eligibility review will see stability maintained, even if it hurts the economy in the short term
The mainland's exchange rate strategy is once again in the spotlight amid renewed talk of the need for a weaker currency as the central bank looks for effective tools to revive the economy.
However, market players argue that Beijing may continue to stick to a stable yuan strategy in order to meet its capital reform goals, even at the cost of hurting the economy in the short term.
A strong currency was one of the key factors to blame for unexpected tumbles in mainland imports and exports in April, with analysts having expected a rebound from depressed levels in February and March. The People's Bank of China followed up with its third interest rate cut in six months on Sunday.
The yuan has weakened by around 0.59 per cent against the US dollar since July. But the euro and yen, the currencies of the mainland's second- and third-biggest trading partners, have weakened against the greenback by 18 per cent and 15 per cent since then. As a result, the yuan has risen by around 13 per cent against a basket of US dollars, euros and yen in the period, according to DBS.
Market players say there could be a short-term correction for the yuan against the US dollar, with the central bank intervening less in the currency market by setting weaker benchmark midpoint prices. However, Beijing is seen as likely to embrace only relatively limited change in its currency strategy, at least until the International Monetary Fund completes its review of the currency's eligibility to join the special drawing rights (SDR) basket.
"Short-term correction is highly likely, but people should not over read," DBS economist Nathan Chow said. "China would not join the currency war. The dynamics of Chinese exports are a lot different from a decade ago - more and more Chinese manufacturers are moving their production base outside the mainland and that means a stronger currency won't help them."
He said DBS was working on raising its year-end target price for USD/CNY to a stronger level, with the US dollar likely to rise more slowly as the US Federal Reserve is expected to delay interest rate increases.
The onshore yuan weakened by 0.03 per cent, or 19 basis points, to 6.2102 against the greenback yesterday, the weakest level in two weeks, while the offshore yuan lost 0.01 per cent, or 4 basis points, to 6.2117.
Barclays economist Chang Jian said in December that the yuan was overvalued by 10 per cent to 15 per cent - which was dragging down economic growth by half a percentage point a year, yet Beijing seems to be tolerating this damage as the cost of opening up its capital account.
Another factor that might make the central bank reluctant to see a sharp decline in the yuan is the risk of capital outflow. The mainland's foreign exchange watchdog said in its annual report released yesterday that it would see "two-way moves" of capital flow in financial and capital accounts this year. The mainland's foreign reserves shrank by US$263 billion between July and March.
Market forces would seem to predict a lower yuan on the back of lower interest rates.
Normally, with interest rates being cut on the mainland and the United States expected to raise rates this year, there would be a natural weakening of demand for yuan and strengthening of demand for the US dollar, as mainland savings and government securities became relatively less appealing investments due to falling returns.
However, some market analysts said that spread impact might be limited due to the fact the mainland's capital markets were largely closed.
"China's capital account is still more closed than others, and hence the transmission between interest rates and FX is much looser than it may be for other currencies," HSBC economists led by Qu Hongbin said. "In fact, if the policy easing improves investor sentiment because of better economic growth prospects, it may actually support the RMB broadly and offset the impact of reduced carry.
"The current calming of the USD bull run is creating balanced flow pressures for the renminbi, making both cyclical easing and structural reform more palatable in the near term."
Standard Chartered currency strategist Eddie Cheung echoed those sentiments.
"Currently, two factors are offsetting the negative FX impact from a rate cut," he said. "The first is the upcoming SDR review by the International Monetary Fund, before which I think the central bank would like to keep the currency steady. The second is the market is taking it as a positive hint that the central bank is using additional measures to prop up the economy."
