Chinese Renminbi – Squaring the Circle
China’s exchange rate policy is one of many significant uncertainties or “known-unknowns” for 2017 (as it arguably was in 2016 and prior years).
The market’s focus is still very much on the rise in USD-CNY but Chinese policy-makers are keen to emphasise the importance of the Renminbi’s performance against a basket of currencies – the CNY Nominal Effective Exchange Rate (NEER). This comes as no surprise.
The monthly pace of CNY NEER appreciation or depreciation has rarely exceeded 3% in the past seven years, suggesting that policy-makers have sought to control the Renminbi’s rate of change.
Large (and well documented) capital outflows from China have been the main source of Renminbi pressure but China’s current account surplus-to-GDP ratio has also edged lower to around 2.5% due to a rising deficit in the services balance. This perhaps dents the argument that the Renminbi is still materially undervalued.
Moreover, despite the Renminbi’s gain in competitiveness in the past year, China’s trade surplus has somewhat counter-intuitively shrunk, not increased. This may be due to price effects outweighing demand-effects (for exports) and still strong credit-fuelled Chinese imports.
In response to quarterly capital outflows of between $100bn and $200bn since late 2015, the PBoC intervened in the FX market to the tune of about $280bn in January-November.
This strong commitment likely reflects the perceived economic and geopolitical benefits of limiting the Renminbi’s depreciation.
Near-term, I think the PBoC may continue to see some value in a broadly stable Renminbi or only very modest CNY NEER depreciation. If capital outflows re-accelerate this would likely require the introduction of further capital controls and aggressive FX intervention. This is certainly an option in the short-run.
If capital outflows stabilise or recede, the PBoC may be able to slow or even stop FX intervention. This is not a totally unfeasible scenario if global yields stabilise and a slightly stronger CNY attracts capital back into China or if capital controls take greater effect.
In the more unlikely scenario whereby China experiences capital inflows, which last happened in Q1 2014, I would expect the PBoC to have limited appetite for rapid and/or sustained Renminbi appreciation and instead use this opportunity to rebuild FX reserves.
Chinese Renminbi – Still a riddle wrapped in a mystery inside an enigma
I argued in Paradox of acute uncertainty and strong consensus views (3 January 2017) that China’s exchange rate policy going forward is one of ten significant uncertainties or “known-unknowns” for 2017. Arguably the question of the Chinese Renminbi’s path was just as relevant (and difficult to answer) in 2016 and prior years, a product of China’s increasing weight in the global economy and international geopolitics, ongoing structural changes in its balance of payments and Chinese policy makers’ complex and sometimes contradictory goals.
Importance of Renminbi Nominal Effective Exchange Rate (NEER) – Nothing new
The market’s focus is still very much on the USD-CNY spot rate, which has been on an up-trend for the past two years (see Figure 1). But Chinese policy-makers are clearly keen to emphasise the importance they attach to the Renminbi’s performance against a basket of the currencies of China’s largest trading partners – i.e. the CNY Nominal Effective Exchange Rate (NEER). In late-2015 the People’s Bank of China (PBoC) officially confirmed that it tracked the CNY NEER but there is evidence suggesting that this measure has been the focus of Chinese policy-makers for many years.
This should come as no surprise. While the USD-CNY exchange rate remains of great importance given that the majority of China’s hard-currency debt is dollar-denominated, the United States accounts for about 18% of China’s total merchandise exports, down from 21% a decade ago (see Figure 2).
Indeed the China Foreign Exchange Trade System (CFETS), the PBoC’s interbank trading and foreign exchange division, announced on 29th December that it would adjust the way its calculate the CFETS CNY Index (effectively a proxy for the NEER) on 1 January 2017 and that the weight of the US Dollar would be cut to 22.4% from 26.4% (see Figure 4).
The CFTES Index still gives greater weight than the BIS basket to the Dollar and to Asia-Pacific currencies but excludes the Taiwan Dollar, Indian Rupee and Indonesian Ruppiah. This leads to some small discrepancies between the two baskets but the overall trends are almost identical (see Figure 3).
Renminbi NEER – Policy tool
I have long argued that the CNY NEER is not just an interesting arithmetic construct but effectively a policy tool. Chinese policy-makers may clearly struggle to dictate the CNY NEER’s long-run level in the face of powerful structural changes, but they arguably try to manage the basket over shorter time frames to fulfil their economic, financial and other objectives. For starters a degree of predictability in the CNY NEER is helpful to Chinese exporters.
Indeed I note that the monthly pace of CNY NEER appreciation or depreciation has rarely exceeded 3% in the past seven years (see Figure 5). Capital account ebbs and flows, seasonal patterns and mean-reverting properties may have contributed to this reasonably tight range, but policy-makers will conceivably have sought to control the Renminbi’s rate of change even if they have only limited control over its long-term trend. Put differently, the PBoC may not have a say in the Renminbi’s final destination but has the tools to help control how it gets there.
Chinese merchandise trade surplus narrowing despite more competitive Renminbi
The CNY NEER’s monthly pace of change was stuck below zero (depreciation) throughout most of 2016 which of course tallies with the CNY NEER weakening about 6% in 2016 (see Figure 1). Large (and well documented) capital outflows from China have been the main source of pressure on the Renminbi. Moreover, China’s current account surplus-to-GDP ratio remains modest and has edged down to around 2.5% from over 3% a year ago mainly due to a rising deficit in the services balance – a fact which has received far less media attention (see Figure 6).
Capital outflows alongside a shrinking current account surplus would suggest, all other things being equal, that the CNY may not be significantly under-valued. Indeed, while the US Treasury argued in its semi-annual report on foreign-exchange policies on 19th October 2015 that the Renminbi remained “below its appropriate medium-term valuation,” it refrained from characterizing China’s currency as “significantly undervalued,” as it had in each foreign-exchange report since May 2012. The CNY NEER has since depreciated 5.5% according to my estimates and President-elect Trump has been openly critical of China’s exchange rate policy.
However, despite the Renminbi’s gain in competitiveness in the past year, China’s trade surplus has shrunk, not increased (see Figure 7). The growth in the dollar-value of Chinese imports has picked up while exports have continued to contract (see Figure 8). Actually, in recent years the Chinese trade balance has improved/deteriorated alongside a stronger/weaker Renminbi, which runs counter to the common understanding that a less/more competitive currency should in theory lead to a deterioration/improvement in the trade balance (the British government is certainly banking on a more competitive Sterling narrowing the UK’s record high current account deficit).
There are a number of possible explanations for this counter-intuitive trend. During periods of Renminbi appreciation in, the $-value of US imports from China has continued to rise, suggesting that the price effect has outweighed the demand-effect, in turn pointing to limited substitution effects (there are few alternatives to buying from China). Conversely, when the Renminbi is depreciating the demand for Chinese exports does not rise or at least not fast enough to compensate for the fall the $-unit value (i.e. the demand effect is insufficient to counteract the price effect).
At the same time the $-value of Chinese imports does not fall sufficiently to offset this fall in the $-value of exports or worse the $-value of imports rises because domestic demand is strong and the cost of energy imports is rising as has been the case in recent months. The net result is a shrinking Chinese trade surplus alongside a weaker Renminbi.
Policy-makers’ response to capital account outflows – controls and FX intervention
Figure 9 shows that net capital outflows, which are defined as net Foreign Direct Investment (FDI), portfolio flows, other flows and errors and omissions, hit about $200bn in Q3 2016 (or 7.2% of GDP) while the IIF estimates that outflows hit $70bn in October and $96bn in November (or about 8.5% of GDP). Data for December are not yet available but capital outflows in Q4 were conceivably the largest quarterly outflow since 2008. Note that FDI inflows into China slowed in H2 2016, which at the margin would have contributed to the deterioration in China’s capital account (see Figure 10).
In response, the PBoC opted to use its FX reserves to partly neutralise some of these outflows. Its willingness to intervene in the FX market to the tune of about $280bn in January-November, accounting for estimated currency-valuation effects, and use 8% of its FX reserves (equivalent to 2.5% of GDP) points to a strong commitment to limit the Renminbi’s depreciation.
This may seem counter-intuitive given the fall in China’s trade surplus. But, as I argue above, Renminbi depreciation may only have a negligible or even no impact per se on the trade surplus. Moreover, the PBoC likely saw benefits to limiting the pace of Renminbi weakening.
First, a weaker Renminbi increases the CNY-cost of servicing significant US dollar-denominated debt. Second, rapid depreciation is inflationary at a time when inflation is rising domestically (particularly Producer Price Inflation) and broadly stable globally. Finally, Chinese policy-makers may have wanted to avoid antagonising US and international trading partners ahead of the Renminbi’s inclusion in the IMF SDR basket in October. Accepting a faster pace of depreciation would have in all likelihood led to even greater capital outflows and Renminbi pressure, setting in motion a vicious cycle difficult to control or requiring far more aggressive FX intervention (and an even larger fall in central bank FX reserves).
PBoC FX intervention (selling dollars) in January-September stopped short of drawing a line underneath the CNY NEER, which weakened about 8% (see Figure 12). I would argue that the PBoC probably saw some value in a slightly more competitive currency following the CNY NEER’s 10% appreciation in 2014-2015 and would have in any case been reluctant to use large chunks of its FX reserves early in the game.
The intensification of capital outflows in October-November, driven in part by higher US yields and Trump’s promise of US-centric reflationary policies, prompted Chinese policy-makers to introduce a number of capital controls in early November and the PBoC to step up its FX intervention. The CNY NEER appreciated nearly 2% over those two months. Balance of payments data are not yet available for December but the CNY NEER was broadly flat in the month.
More detailed data will shed light on whether this Renminbi stability was the product of a larger trade surplus, smaller capital outflows and/or continued aggressive FX intervention – I would venture it was a combination of the last two. It is perhaps too early to ascertain whether capital controls are proving effective but anecdotal evidence suggests that they are at best a modest deterrent to capital leaving China. Capital outflows may have subsided in December simply because markets were taking a breather, with global yields stabilising after their vertiginous climb following Trump’s election victory on 8th November.
Greater Renminbi stability…for now at least?
Assuming that the Chinese current account surplus and FDI inflows do not change materially near-term, underlying capital flows and the PBoC’s policy response – including the depth and effectiveness of capital controls and FX intervention – are likely to remain the main Renminbi drivers for the foreseeable future.
Near-term, I think that the PBoC may continue to see some value in a broadly stable Renminbi or only very modest CNY NEER depreciation. If capital outflows re-accelerate this would likely require the introduction of further capital controls and aggressive FX intervention. This is certainly an option in the short-run – the PBoC’s FX reserves still amount to a reasonable 27% of GDP and a sizeable 24 months of merchandise imports according to my estimates (see Figure 13).
If capital outflows stabilise or recede, the PBoC may be able to slow or even stop FX intervention. This is not a totally unfeasible scenario if global yields stabilise and a slightly stronger CNY attracts capital back into China or if capital controls start to take greater effect. In the more unlikely scenario whereby China experiences capital inflows, which last happened in Q1 2014, I would expect the PBoC to have limited appetite for rapid and/or sustained Renminbi appreciation and instead use this opportunity to rebuild its FX reserves.
The outlook for the Renminbi is of course clouded by the increasingly complex relationship between the US and China since Donald Trump’s election victory and his threats to reintroduce tariffs on imports and denounce China as a currency manipulator. If Trump carries out his threats, Chinese policy-makers could be incentivised to allow the Renminbi to weaken more forcefully.
 I have by extension argued that markets should also pay greater attention to the NEER in other major economies, including the eurozone. While the EUR/USD cross has dropped rapidly, the Euro has been one of the most stable developed currencies in NEER terms, as I have stressed in the past 18 months (see Euro weakness, uneven export performance, 3 August 2015).