by Ron Leven.
When the People’s Bank of China (PBoC) let CNY weaken by more than 3% against USD last August, its intent remained unclear. Subsequent aggressive intervention suggested a commitment to a broad USD peg, with seeming intent to hold the 3-year trading range. However, the ensuing 4.5% declines in CNY and CNH – to levels last seen in 2010 (as shown in the chart below) – are clear evidence that the PBoC’s intent may not only be for a significantly weaker range, but perhaps an abandonment of the USD link altogether.
Exhibit 1. CNY and CNH vs. USD and Thomson Reuters/HKEX RXY Global Trade-Weighted Index
On a trade-weighted basis, USD has appreciated roughly 20% over the past two years and the USD link to CNY has forced substantial CNY appreciation against other currencies, in particular, other Asian currencies. The PBoC could abandon the USD peg in order to halt this indirect loss of competitiveness against its neighbors. Speculation has emerged that the PBoC is now switching its focus to pegging CNY to a basket of currencies rather than just the USD. This belief was abetted by their decision earlier this year to begin publishing a weekly CNY multi-currency index. The chart above also shows Thomson Reuters and Hong Kong Exchange’s newly released RXY Global CNY (.RXYY) and RXY Global CNH (.RXYH) performance indices against a basket of currencies (RXY Indices Methodology). CNY has also been falling against this basket since August suggesting that, even if the PBoC ultimately intends to use a basket as the new anchor, it is willing to see a weaker CNY. Could they be targeting the prior 2013-14 range?
Exhibit 2. Nominal and Real Trade-Weighted CNY Indices
It is certainly conceivable that the Chinese government felt that they have yet to adequately reverse the loss of competitiveness created by the strong USD link and China’s relatively high inflation rate. The chart above shows the real exchange rate appreciated in parallel with the move in the nominal CNY index, approaching the range that prevailed before the USD surge. Before we can conclude if the PBoC will stabilize CNY once it is back in the old range, it would be helpful to understand its motivation for letting the currency weaken in the first place.
It’s not clear that trade was the main driver
We are skeptical that competitiveness was the main motivation for CNY weakening. As shown in the chart on the next page, exports have been drifting lower since 2014; however, the trade balance remains flat as imports have also fallen. Therefore the traded-goods sector is not subtracting from GDP growth. Moreover, the CNY real trade-weighted decline of about 8% is too modest to meaningfully impact trade. Also, the feed-through would realistically take at least a year and potentially be muted by currency declines in countries competing with China.
Exhibit 3. Chinese Exports and Merchandise Trade Balance (12 Month Moving Averages)
It’s the capital account
The chart below shows that China’s foreign reserves have been declining since early last year. The combination of a substantial current account surplus and falling reserves is clear evidence that, despite exchange rate controls and a declining currency, China is experiencing substantial net capital outflows. The decline in reserves represents use of foreign exchange to buy CNY to maintain its value. In the absence of this intervention, CNY would have seen much bigger declines. But selling foreign reserves also contracts the money supply; indeed, the yearly growth in M1 has generally tracked foreign reserve changes. The surge in M1 emerged as the stock market went into steep decline and is probably a byproduct of a PBoC attempt to buoy equity prices. The Chinese central bank may feel that maintaining the USD link is compromising their ability to support stock prices.
Exhibit 4. Chinese Money Supply (M1), Foreign Reserves and Shanghai Composite Index – Y/Y %
At home on what range?
If competiveness is the driver, it is likely CNY would continue declining at a fairly rapid pace as a substantial undervaluation of the real exchange rate is required to engineer a substantial shift in trade flows – and it will take several years to play out. A capital account driven motivation is more problematic. Investor concerns of further CNY weakness would spark more outflows and intervention – so we expect the government will try to defend the prior range. But which range? We suspect the PBoC has made the decision to shift to targeting a basket rather than USD, but it will take more evidence to have confidence in this. Regardless which range the CNY settles in, poor equity performance would probably spark spontaneous capital outflows which could force another downward adjustment in the currency. CNY is apt to be biased to weaken at least into the end of this year but equities rather than the trade balance is likely to be key driver.