On Friday, the People’s Bank of China (PBoC) decided to disclose the components of their trade weighted index for the renminbi (RMB); the China Foreign Exchange Trade System (or CFETS RMB Index). The concept of a trade weighted basket is nothing new, just the disclosure of the composition and weightings. In fact in 2007 we wrote that, “We know from comments made by officials from the People’s Bank of China, that the central bank manages the exchange rate against a basket of currencies. The basket weights are not disclosed but are believed to be based on the size of trade with China.” Even before this and prior to the unpegging of the RMB from the dollar, in July 2005, one could have deduced from the meetings between the PBoC and the MAS (Monetary Authority of Singapore) that the PBoC would follow the example of the MAS and abandon its peg in favour of such a basket. This it has been doing for the past decade.
What might be considered new is the market’s reluctance to believe the policy announcements of the PBoC. As such the central bank has made this radical step of complete disclosure of the basket, contrary to the practices of the MAS et al., in order to spoon-feed the media with an accurate way of evaluating the RMB’s relative strength and to help counter prevailing misconceptions. In their polite phrasing, "to help guide market participants to shift their focus from the bilateral RMB/USD exchange rate to the effective exchange rate, which is based on a basket of currencies ...This will contribute to maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level."
This of course raises doubts as to whether the RMB will hold up to a strong dollar in the short term as US policy diverges from a more stagnant global economy elsewhere. (However it reaffirms that the Chinese authorities have no intention of driving a devaluation themselves in a vain attempt to boost the economy. It seems there are a few intransigent investors who continue to believe the myth that the August policy announcement - to make the RMB fixing market led - was due to a policy of devaluation rather than a policy of internationalisation.) If indeed the US rate policy divergence extends this already prolonged dollar bull run - which is far from certain - then the RMB will exhibit some relative weakness over the short term. Capital Economics, for example, see some depreciation over the coming 12 months with the RMB/USD rate returning to current levels by end 2017 (6.46 today, 6.80 in 2016, 6.50 in 2017). Meanwhile investors in the currency are being paid a substantial carry for holding the currency. Currently the annualised 1 month forward rates for CNH yields around 5%. An example of such potential is that although the RMB is at a “four and a half year low” (since end June 2011 - today) the total return over that period, according to Bloomberg, is +12.8% for CNY and +11.0% for CNH versus the US dollar.
Moreover we see little threat of a significant decline of the RMB on the basis that it would not do much to support the Chinese economy, would risk destabilising capital outflows and does not follow the current trend of China’s increasing international importance. Furthermore the PBoC is consistently reminding markets that the RMB is a strong global currency. This latest announcement is the last of a string of such reminders and is not a policy shift. Also many of those with short term concerns for the RMB seem to miscount the importance of a number of significant positive factors:
- The momentum of integration of China into international markets should not be underestimated. Presently markets remain fundamental underweight in Chinese bonds, equities and the RMB itself.
- The PBoC still have their colossal arsenal of FX reserves equivalent to over USD 3.4tn. This is down 14% from its peak 18 months ago, but this is only a modest adjustment with the most significant contributor to the reduction being, not the pressure from a shift in market sentiment but, the lower value of non dollar assets; estimated to be around 30%.
- A slowdown in growth does not translate directly into a weaker currency. For example during Japan’s industrialisation, the yen appreciated 400% over 40 years from the early 1970's even as its growth halved in each of those decades.
- A stable RMB versus the CFETS Index does not exclude a continuation of the current steady trend of appreciation versus the basket nor does it necessarily mean weaker against the dollar.
It is worth noting that the CFETS basket’s four largest currency weights are: USD 26.4%, EUR 21.39%, JPY 14.68% and HKD 6.55%; accounting for ~70%. Nine other trading partner currencies make up the remainder, interestingly with the omission of the South Korean won. This comprises a much higher weighting of the US dollar than the BIS basket which only has a 17.8% dollar weighting. The announcement also mentioned the, still heavily dollar weighted, SDR basket, to which the RMB will be included by October next year. Against all of these baskets the renminbi is expected to remain steady or see some gradual appreciation.
Returning to dollar expectations in a post rate hike environment it is well worth remembering that in past experiences we have seen a weakening dollar post the first rate increase. For example, six months following the Fed’s previous tightening in June 2004, the dollar index (DXY) declined by 9%. Such a possibility should not be so easily dismissed. Ahead of the impending US rate hike, the dollar has already surged against most major currencies, the DXY index is up ~8.4% so far this year. During this time, CNY was down 3.87% against the dollar, while CNH has fallen 4.79%. However, within this timeframe, the euro has tumbled -9.21% (down over 5.5% against CNH).
We believe that this most recent announcement is just another step in improving transparency and shows that the policy makers intend to make the exchange rate policy increasingly flexible and better understood in the meantime. We expect that if the USD appreciates against other major currencies, the PBoC will be willing to accept some depreciation in the RMB against the dollar, on the condition that versus the basket it will remain relatively stable. We see such potential for depreciation versus a strong dollar being only moderate and short term. Meanwhile total expected returns from exposure to the currency (including carry) still seem attractive over all horizons and the ongoing trend continues to suggest growing importance of China and the RMB in international markets in the coming years.