On September 16, the 10-year Sino-US spread was inverted to 74 basis points, and the depreciation pressure on the RMB exchange rate was self-evident, with the RMB once surging to 7.0254 against the U.S. The “breaking of 7” of the RMB against the U.S. dollar immediately drew the attention of the whole market. So far this year (as of September 16, the same below), the RMB has depreciated by 9.88% against the USD, but compared to other currencies, the performance of the RMB has been relatively solid.
On August 26, 2022, at the central bankers’ meeting in Jackson Hole, Fed Chairman Powell’s hawkish statement implied that the Fed would continue its aggressive rate hike and tapering policy. Since then, the yield on the 10-year U.S. Treasury note has moved higher again, climbing to 3.44% by September 16. Wall Street predicts that the U.S. 10-year Treasury yield will rise to 3.75 percent by the end of the year and will peak at 4.0 percent in 2023. So far this year, the dollar index has risen 14.65%.
Both the euro and the yen have fallen to 20-year lows against the dollar. As of Sept. 16, the dollar had depreciated 38.4 percent against the yen from the end of 2020 all the way through the year. The euro, which has been falling against the dollar since June 2021, depreciated by a total of 22% by Sept. 16. The British pound has also been on the decline since June 2021, depreciating by 24.3% against the dollar by September 16. This is still the currency trend of major economies, and some developing countries have seen even more outrageous currency depreciation.
In terms of horizontal comparison with other currencies over the same period, the RMB real effective exchange rate index has only declined slightly by 2.8% this year, the reason behind this is that the RMB has appreciated significantly against other mainstream currencies, with the RMB appreciating 3.1% against the Euro, 6.2% against the British Pound and 12.6% against the Japanese Yen since the beginning of the year. From the perspective of a basket of exchange rates, the overall CFETS RMB exchange rate index is still appreciating from the beginning of the year, reflecting that the RMB exchange rate index is not weak so far this year. This indicates that the weakening of the RMB is only relative to the USD.
The logic behind the “broken 7” exchange rate
The analysis of the bilateral exchange rate, in the long run, depends mainly on the difference in labor productivity between the two countries, that is, in the framework of the “Balassa-Samuelson effect”. However, in the short to medium term, the main factors determining the bilateral exchange rate are the difference in economic growth between the two countries, the inflation differential and the interest rate differential between the two countries, as well as the sentiment of international investors derived from these three factors.
Since 2022, the RMB has depreciated against the USD, mainly due to the rapidly widening long-term interest rate differential between the US and China and the pessimistic investor sentiment caused by expectations of economic growth.
Since 2020, the U.S. economy has grown strongly, with the U.S. manufacturing PMI consistently above the RongKu line and a more stable level of non-manufacturing PMI. The preliminary U.S. University of Michigan Consumer Confidence Index for August was 55.1, up 7 percent from the previous year. On the capacity side, capacity indicators, such as industrial, manufacturing, and consumer goods output, have been picking up since the second quarter of 2020 and have surpassed their pre-epidemic levels since the second quarter of 2022.
In addition, the U.S. job market remains strong, with 315,000 new nonfarm payrolls in August, higher than the expected value of 300,000, and an unemployment rate of 3.7%, the highest since February this year; the labor force participation rate of 62.4%, the highest since the epidemic. The unemployment rate has been declining since April 2020 at 14.7% and will largely return to its pre-epidemic low by the second quarter of 2022, demonstrating strong employment resilience.
The Russian-Ukrainian conflict has brought about rising international energy prices and sudden inflationary pressure in the U.S. The U.S. CPI reached 8.5% year-on-year in July. Against this backdrop, the Federal Reserve has chosen to tighten its monetary policy, from the initial reduction in the size of quantitative easing to the subsequent successive rate hikes, and the rate hikes are large and expected to accelerate tapering in the future.
After the market expects the Fed to keep tightening monetary policy, the U.S. 10-year Treasury yield has climbed significantly, from the beginning of the year all the way up to 3.44% now. Investors now expect the Fed to raise interest rates by 75 basis points next and expect the yield on the 10-year U.S. Treasury to rise to 4 percent next year.
In China, economic growth slowed significantly in the second quarter, with GDP growth of just 0.4% year-on-year, as many parts of the country were hit by the epidemic. Concerns in the foreign exchange market about the future of the Chinese economy followed.
In order to achieve stable growth, the central bank adopted a moderately accommodative monetary policy. The central bank cut the medium-term lending facility (MLF) and open market reverse repo (OMO) rates by 10 basis points each on Aug. 15, exceeding market expectations. It then guided the loan market offer rate (LPR) down in line with the trend, including a 5 basis point cut for the 1-year period and a 15 basis point cut for the 5-year period and above, increasing support for medium- and long-term loans such as real estate mortgages.
The reverse operation of the central bank and the Fed caused the long-term interest rate differential between the two countries to widen rapidly. By Sept. 16, the U.S. 10-year Treasury yield was 74 basis points higher than the Chinese 10-year Treasury yield. The inverted and widening spread between the U.S. and China could trigger some cross-border capital flows from China to the U.S., which could depress the yuan against the dollar.
Since July and August, the epidemic has eased. On September 16, the National Bureau of Statistics announced the economic data for August. On the whole, the economy has gradually recovered, infrastructure has remained relatively resilient, manufacturing investment is still strong, the year-on-year growth rate of total retail sales of social consumer goods has rebounded to 5.4%, and the national urban unemployment rate has been surveyed. Further downside to 5.3%.
However, economic concerns remain. Exports fell sharply in August, real estate was weak, and various real estate data still failed to stabilize and rebound, and were still in the process of bottoming out. The unemployment rate for youth aged 16 to 24 in August was 18.7%, indicating that youth employment pressure is still relatively high. In addition, both corporate deposits and household deposits showed super-seasonal growth in August, reflecting the weak willingness of enterprises and households to spend.
Under such a situation, the central bank will pay more attention to the domestic economic trend than the exchange rate. After all, the important factor that determines the future exchange rate trend is the strong growth of the future economy, so the central bank still chooses a moderately loose monetary policy. The six state-owned banks of China Construction Communications and Postal Savings Bank, as well as China Merchants Bank, announced in unison that they would cut interest rates on personal deposits. This reverse operation will further widen the 10-year interest rate gap between China and the United States in the short term, increasing the short-term depreciation pressure of the RMB.
The impact of a weaker renminbi
For example, airlines, real estate, etc., will worsen their balance sheets. But for the export processing industry, it will obviously increase their international competitiveness and will improve their business conditions. in August, China’s exports grew by 7.1% year-on-year in dollar terms, a sharp drop from the growth rate in June (17.9%) and July (18%), and a moderate devaluation is good for stabilizing exports.
In the financial markets, the outflow of funds will increase the volatility of the market.
As far as the stock market is concerned, overseas funds can influence the Chinese stock market through the Shanghai-Hong Kong Stock Exchange, Shenzhen-Hong Kong Stock Exchange and QFII, but the current openness of the Chinese stock market is not too high, and the change of these funds will only have a limited impact on the market in the short term, and the main factor affecting the stock market in the medium and long term is the trend of the Chinese economy. If the Chinese economy can return to a higher growth rate in the future, or form a new economic growth cycle, then the Chinese stock market will naturally come out of the good market, and of course the RMB exchange rate will be strong.
However, we cannot ignore that the market sentiment brought by the strong dollar will increase the volatility of the financial markets, and if we do not grasp the rhythm, it may trigger panic among investors, which needs to be wary.
Of course, at present, the central bank has many tools to prevent sharp fluctuations in the local currency exchange rate, such as counter-cyclical factors, foreign exchange deposit reserves, forward foreign exchange sales reserves, capital flow management, and macro-prudential management at the foreign exchange level. And judging from the trend of the renminbi this year, the central bank has also used these tools. For example, after the Federal Reserve announced interest rate hikes this year, the central parity rate of the renminbi against the US dollar exceeded market expectations. In contrast, the exchange rate of the RMB against the US dollar has remained relatively stable, which shows that the central bank is already using these tools to adjust.
Even in the worst case scenario and investor panic, as China has not fully opened its capital account, the central bank can limit short-term capital outflows in the event of sustained large-scale capital outflows, such as limiting the number of foreign exchange exchanges, or levying trusteeships. Bin tax and other methods to stabilize the market.
Therefore, given the moderate depreciation of the RMB against the U.S. dollar and the relative flexibility of the RMB exchange rate formation mechanism, there is no need to worry about the sharp depreciation of the RMB, much less the financial market turmoil that some investors worry about.
Prediction of the future trend of RMB
The trend of a country’s exchange rate is ultimately determined by the country’s economic development capability, that is, how the RMB exchange rate will trend in the future depends on the fundamentals of China’s economy in the future.
Therefore, China’s monetary policy is still based on the fundamentals of its own economic development, and the exchange rate market is only one factor that needs attention in the short term. At present, China’s economy is still lacking in aggregate demand, so monetary policy will remain moderately loose to achieve stable growth, and interest rate cuts will remain policy options in the future. Moreover, in fact, under the premise that the world’s major currencies are depreciating sharply against the US dollar, the moderate depreciation of the RMB against the US dollar will help maintain the stability of the effective exchange rate of the RMB, and there is no need to hold it dead.
To assess the future direction of the US dollar index, it is also necessary to look at the relative position of the euro area and Japan. Since 2021, the manufacturing and service PMIs in the euro area have also been on a downward trend. In August, the manufacturing PMI recorded 49.6, falling below the line of prosperity and decline and hitting a new low in 18 months. Inflation in the euro zone hit 8.9% year-on-year in July, driven by the energy crisis.
In Japan, the macroeconomic situation is still hardly optimistic. 2022 years, the impact of the Russia-Ukraine conflict and rising energy prices, Japanese machinery orders fell and the CPI index rose sharply. Japan is highly dependent on energy imports, and imported inflation poses a big challenge to the Japanese economy. The BOJ’s assessment of the downside risks to the economy remains higher than the upside risks to inflation and continues to maintain an accommodative policy orientation.
In the short term, inflation in the U.S. will remain high and the economy is still operating in an expansionary region, and the Fed is expected to continue to implement interest rate hikes and tapering and adopt a tight monetary policy.
Taken together, the dollar index is expected to rise further in the coming period.
Since China implements a monetary policy based on China, even if the exchange rate of RMB against the US dollar “breaks 7” in the short term, there is no need to make a fuss. With the evolution of the Fed raising interest rates and shrinking the balance sheet, the US economy may enter a recession in the future. In the future, China will focus more on economic growth. If the economic growth rate picks up significantly, the exchange rate of RMB against the US dollar will return to the appreciation channel.