Thursday, 18 July 2019

Two-way traffic

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The renminbi is on track for its worst year against the US dollar since the peg was partially removed in 2005 after rising steadily for years. What used to be a one-way bet is now more volatile than ever.

Cars drive along a main road in central Beijing.

Two-way traffic

Source: REUTERS/David Gray

Cars drive along a main road in central Beijing.

After winning Asia’s emerging-market currency race last year with a 2.9% rise against the US dollar, it took less than three months for the renmimbi to wipe out those gains.

The weakness was seen as deliberate attempt in Beijing to thwart illicit inflows and lay the groundwork for a more flexible foreign-exchange trading band. It was, however, the severity of the decline that spooked investors, who were already nervous about lingering risks in the credit and property markets, as well as signs of slowing economic growth.

Before this year, the renminbi had handed investors a 25% return with minimal volatility in the nearly a decade since the partial removal of the currency’s peg to the US dollar, and a positive weekly return of 66% at the time, according to the Peterson Institute.

A 3.6% slide come April has changed that picture completely. The renminbi is no longer a one-way bet.

Such a turnaround, however, was not completely unforeseen and market reforms are likely to determine the renminbi’s future direction for some time to come.

Beijing had already signalled in November its desire to speed up currency reform, fuelling speculation of a squeeze to introduce greater two-way flows. In the weeks leading up to the widening of the trading band in March, it was clear that the People’s Bank of China was pulling the renminbi’s official rate lower, and asking the major state-owned banks to buy dollars.

“China’s commitment to achieving slower, more sustainable, quality growth implies that the renminbi will continue to trend higher, even if that path will be volatile.”

The eventual doubling of the trading band on March 17 exceeded expectations and occurred a little sooner than many had envisaged. Still, it did not stop the downtrend and some saw a weaker renminbi as a form of economic stimulus at the end of China’s property boom and declining factory output.

Indeed, if the authorities aimed to provide an extra boost to struggling exporters, the efforts appear to be working. June data from HSBC shows that the smaller, export-oriented factories have returned to growth after a five-month hiatus, and analysts expect further improvements as global demand recovers.

China’s GDP grew 7.5% in the second quarter from 7.4% in the first three months with full-year expansion either set to meet or even surpass Beijing’s 7.5% target.

That assessment would provide scope for the renminbi to resume its gradual appreciation as China’s economy stabilises. The unit has risen nearly 1.0% against the dollar since the end of April.

Returning to trend?

In a July 15 report, Nomura analysts called for further appreciation towards the year-end with second-quarter forex reserve data highlighting the PBoC’s success in significantly reducing speculative capital flows.

Goldman Sachs also sees the renminbi’s upward potential against the dollar, with a three-month forecast of 6.16 and six-month projection of 6.15 from around 6.21 currently.

However, further down the track, Goldman Sachs sees one-year non-deliverable forwards – considered the best available proxy for forward positions on the tightly controlled currency – slipping to 6.26.

UBS, which expects growth to dip below 7.0%, also believes the renminbi will slip to 6.25 as at end-2014 and 6.35 as at end-2015.

The Swiss lender says a weaker renminbi will be especially appealing for China, with the US dollar likely to rise and China to face further upward utility and resource-cost adjustments and higher unit labour costs. The renminbi is also no longer undervalued, according to UBS.

Similarly, ANZ has warned that China’s accelerated efforts to liberalise the capital account may also see increasing capital outflows and a depreciation in the renminbi over the next few years.

Long-term gains

Yet, from a long-term perspective, China’s commitment to achieving slower, more sustainable, quality growth implies that the renminbi will continue to trend higher, even if that path will be volatile.

Indeed, UBS says continued political pressure from the US and other major partners to let the renminbi appreciate implies limited scope for a notable depreciation with a relatively strong and stable unit vital in the internationalisation of the currency.

Then, there is the potential for rising inflation to push for a stronger currency to cap imported costs. Nomura’s Zhiwei Zhang warns that price pressures can rise from the accumulative effects of this year’s “mini-stimulus” with inflation likely to increase to 3.2% in 2015.

Regardless of the direction, it is clear that volatility is here to stay. The resulting risk premium means higher external funding costs for local firms in the overseas capital markets, and a possible capital shortfall for those relying on illicit channels to gain access to cheap foreign financing, according to the Peterson Institute.

Liquidity has dipped. In a sign of poorer market liquidity, China’s overnight repo rate closed near a five-month high of 3.31% on July 11 (now at around 3.28%) and foreign exchange assets grew at the slowest rate in 11 months in May.

The impact of the new renminbi volatility on liquidity conditions might well be the reason the PBoC was contemplating new monetary policy tools, such as pledged supplementary lending, to manage overall liquidity, ANZ analysts said in a July 15 report.

Ultimately, policymakers in Beijing, rather than pure market forces, still determine the renminbi’s value. As China allows market forces to play a bigger role in its domestic system, any conclusion on the currency’s outlook will need to weigh that push for reform with the need for economic growth.

To see the digital version of this report, please click here.

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