China still fighting an uphill battle to stabilise renminbi
The chance is low of a large, one-off adjustment on the yuan’s exchange rate, although we won’t write it off completely
Volatility in the renminbi offshore markets surged at the start of 2017. Due to a sudden dry up of CNH liquidity, the overnight interest rate in the money market – the Hong Kong InterBank Offered Rate (HIBOR) – shot up to 61% on January 6, the highest since the same period of last year.
As the HIBOR represents the crucial funding cost for short-selling the CNH – a trade that has become very crowded lately – the surging rate has led a sharp unwinding of these short positions and a subsequent plunge in the CNH/USD.
Even though the market has quickly normalised after the short jitter with the renminbi stabilizing, it will be wrong to think that China is out of the woods with respect to its depreciating currency and capital outflows.
One factor that could unsettle the current market calm is if the Trump administration announces policies that are detrimental to the Chinese economy after his inauguration.
These may include labelling -- or ordering an investigation of -- China as a currency manipulator, and/or initiating trade protectionist measures against Chinese products.
Against that backdrop, the Chinese authorities have taken a number of precautionary measures to build a firewall against a potential resurgence of market volatility. These include:
- Tightening capital controls by restricting cross-border lending and transfers of funds by banks and corporates, limiting the size and nature of foreign direct investment by Chinese companies and imposing restrictions on the usage of USD by Chinese individuals.
- Active market intervention by deploying foreign exchange reserves. Of the US$110 billion decline in reserves since last October, we estimate that close to US$90 billion was due to market interventions to support the yuan. In addition, the action to tighten CNH market liquidity, as discussed above, could have been orchestrated by the Chinese authorities as a counter attack against speculation in the FX market. The methods of market intervention has therefore become more diverse and innovative. And by moving away from burning FX reserves, it helps the authorities to conserve ammunition and soothe market fears about reserve depletion.
- Re-anchoring expectations by guiding the market focus towards the new CFETS index, which has a reduced weight on the USD, and which has been stable to rising since mid-2016. It is also possible that further refinements to the CNY/USD fixing mechanism may be introduced to make the yuan move more independently from the USD.
Overall, a lot has been done in China to ease market pressure, but there is no guarantee that these efforts will pay off.
As the dominant influence in FX has now shifted to the US, Beijing is in a reactive position and fighting an uphill battle. If conditions deteriorate further, additional measures could be introduced, although the precise method of implementation is difficult to predict.
What about a large, one-off FX adjustment?
We think the chance of a large, one-off adjustment on the exchange rate is low, although we wouldn’t write it off completely, especially having witnessed so many black swans over the past year.
The key reason is that such an adjustment will be extremely difficult to manage, with its impact very hard to predict ex-ante.
Will the market take the move as the end of the adjustment? Or will it see it as the People’s Bank of China throwing in the towel in defending the exchange rate? The latter could deepen depreciation expectations and cause panic in the market.
In fact, such divergent interpretations were exactly what we saw following the August 2015 adjustment, where the CNY/USD was marked up by 1.9% in a single move.
The PBOC told the market that it was a one-off adjustment to realign the fixing and spot rates. But the market interpreted it as the end of the central bank defending the RMB, and hence, short-sellers zeroed in on the short-yuan trade.
Once the (depreciation) genie was out of the bottle, it was difficult to put it back in – it cost the PBOC US$140 billion of FX reserves to stabilise the market in the following two months.
We think that the August 2015 episode taught the PBOC a valuable lesson, in that a shock-and-awe strategy is risky to implement and its consequence can be very difficult to manage.
Beijing may not have the stomach for such a shock in the year of leadership transition, where stability is valued dearly. A one-off move is possible, if the Chinese central bank’s back is pushed against the wall, but we are still far from that state, in our view.
Aidan Yao is Senior Emerging Asia Economist at AXA Investment Managers