Pity the currency trader trying to make sense of the renminbi exchange rate this year.
Following a record 6.5 per cent depreciation last year, investors began 2017 convinced that the renminbi would continue falling. Many predicted it could weaken to around 7.3 per dollar, from 6.95 at the end of 2016. Instead, the renminbi has gained 2.1 per cent this year and 1.6 per cent since May 9, closing at 6.8 per dollar on Thursday.
On the surface, this does not make much sense. While China maintains a healthy trade surplus, official data indicate that outflows through the capital account continue to surpass trade-linked inflows. Both official data and anecdotal reports from traders indicate that the supply of renminbi exceeds demand.
Purchase of foreign exchange by banks on behalf of corporate and household clients, as well as for their own accounts, exceeded comparable renminbi purchases by a combined average of $14bn per month from January to the end of April, according to data from the State Administration of Foreign Exchange.
While surplus purchases are down from a monthly average of $28bn in 2016, these figures still suggest that, on a supply-and-demand basis, the renminbi should be falling.
At the same time, China’s forex reserves have risen for four straight months to the end of June, after falling for 20 of the previous 25 months. That suggests that the People’s Bank of China is no longer selling dollars to support the currency. So what is going on?
Tao Wang, co-head of Asia economics at UBS in Hong Kong, notes that China’s moves last year to tighten capital controls have succeeded in slowing the torrent of outflows to a manageable trickle. She also notes that market expectations often outweigh fundamentals in foreign exchange markets.
“Although there are still outflows, if the outflow is less than what the market expected, the exchange rate may strengthen,” she says.
In addition, direct PBoC support for the renminbi through dollar sales has not completely stopped, despite the headline rise in foreign exchange reserves. This is largely due to valuation effects from changes in exchange rates and asset prices.
A separate PBoC data series, which tracks accumulated foreign exchange purchases by the central bank, but is not marked to market, offers a clearer picture of whether the central bank is buying or selling. By that measure, the PBoC has sold an average of $13bn per month in the year to April compared with $31bn on average through most of 2016.
More important, the PBoC has also found ways to discourage bearish bets on renminbi that do not require deploying precious forex reserves. Last month, the central announced a change to the way it sets the renminbi’s daily fixing.
The introduction of a “countercyclical factor” in the fixing formula essentially grants the PBoC greater discretion to guide the renminbi in a particular direction, even when the previously announced formula pushes in the opposite direction.
“The countercyclical factor sent a strong signal about the PBoC’s intention. The market’s expectations shifted dramatically,” says Xiao Lisheng, deputy director at the Chinese Academy of Social Science’s Institute of World Economics and Politics. “Suddenly all these exporters who were hording their dollar receipts decided it was time to convert to renminbi.”
The PBoC has also moved to punish foreign speculators in Hong Kong’s offshore renminbi market. Acting through state-owned banks, the PBoC has repeatedly squeezed offshore renminbi liquidity, pushing up money market interest rates and thereby raising the cost of bearish bets.
“All those macro hedge funds were massively short, and they’re losing money — not only on China but on other markets as well. So they have very little patience left,” says a trader who bets on Chinese interest and exchange rates at a large European hedge fund.
Perhaps the biggest reason for the renminbi’s recent strength is the dollar’s global weakness. As the “Trump trade”, based on expectations of tax cuts and infrastructure-led stimulus, fizzled, the dollar has given up its post-election gains.
But the renminbi has appreciated less against the dollar this year than other emerging market currencies. As a result, the Chinese currency has actually weakened against a trade-weighted basket of currencies during 2017.
The PBoC said in December 2015 that it would aim to keep the renminbi broadly stable against this basket but, in practice, its commitment to such stability has been uneven.
“If the PBoC were really following a basket, then the renminbi should have strengthened more [versus the dollar]. So I see the recent move as in part a catch-up,” says Ms Wang.
Ultimately, however, the central bank’s shrewd manoeuvrings may only postpone the inevitable. A Reuters poll of forex analyst in late May showed that on average the market still expects the renminbi to weaken to around 7.05 per dollar during the next 12 months.
Additional reporting by Nan Ma