To predict the movements of the renminbi this year, we need to consider three key factors.
First, the internationalization of the renminbi has enhanced the impact of its exchange rate on emerging-market currencies.
Beijing has to take into account potential competitive depreciation of currencies in the region following any depreciation of the renminbi.
Second, sustained expectations of a weaker renminbi might worsen existing capital outflows. That would hurt China’s financial markets and real economy.
Third, there is an increasing correlation between currencies and equities.
Depreciation of China’s currency might add more volatility to its stock markets.
That said, the renminbi is likely to move with a basket of currencies this year.
It hovered last month in a tight range of between 99.96 and 100.84 on the new China Foreign Exchange Trading System renminbi index, which is based on a trade-weighted basket of currencies.
The renminbi eased 0.3 percent against the Bank for International Settlements basket of currencies and 0.76 percent against the International Monetary Fund’s Special Drawing Rights basket.
Meanwhile, China has amassed massive foreign exchange reserves after years of currency appreciation.
That has acted as ballast for the redback. In June 2014, the country’s foreign exchange reserves reached a peak of US$3.99 trillion.
However, those reserves dived more than US$600 billion by the end of last year.
The remaining US$3.33 trillion in foreign exchange reserves is equivalent to 20 months of imports into China and cover the country’s short-duration external debt several times.
In the meantime, global payments and other factors also underpin the renminbi.
China has maintained a trade surplus as a result of bigger declines in imports than in exports.
Service trade deficits have stemmed from outbound travel and from outbound investment by companies and individuals.
The current account surplus has kept shrinking, while the capital account deficit is widening.
That trend will determine the future direction of the renminbi.
Also, expectations of a weaker renminbi mainly stem from strong US economic growth and global capital flows following the raising of interest rates by the United States.
However, historical experience shows there is no direct relation between rate increases and strength in the US dollar.
Nevertheless, economic recovery in the US has exceeded that in other major economies.
The US Federal Reserve has taken the lead in hiking interest rates, while the European Central Bank might expand its monetary easing measures.
The Bank of Japan will impose a negative 0.1 percent interest rate on excess reserves that financial institutions place at the bank, with effect from Feb. 16.
It has joined central banks in the eurozone, Switzerland, Sweden and Denmark in adopting negative interest rates.
That will weigh on the yen as well as the euro and prompt investors to direct capital into the US.
The “impossible trinity” — a principle that states a country cannot enjoy a stable foreign exchange rate, free capital movements and an independent monetary policy all at the same time, but at most two of them – will set the tone for China’s currency policy in the medium term.
The depreciation of the renminbi is closely linked to China’s economic growth.
The country will deepen its economic restructuring this year amid problems like excessive capacity, a high leverage ratio and rising deflationary risk.
Supply-side reform might drag down economic growth further in the short term.
Policymakers need to rely on monetary policy to stimulate growth.
China’s one-year benchmark deposit rate is 1.5 percent, and the loan rate is 4.35 percent.
There is still room to the downside.
If the Fed continues to raise rates, China’s benchmark interest rate might drop further to 1 percent.
And there is also the possibility of an inverted interest rate gap between the US and China.
The availability of yuan and China’s capability to contain financial risks will hold sway in future renminbi internationalization.
Two years of depreciation in the renminbi has affected investor appetite for the currency on the offshore market.
Offshore yuan deposits fell 15 percent in December from a year earlier.
And the offshore market has been more volatile, the interbank rate on one occasion spiking as high as 100 percent.
That has affected offshore bond market and other transactions.
Whether the renminbi can be accepted as a global reserve currency largely depend on investors’ confidence.
Global investors still view the redback as a typical emerging-market currency.
Renminbi internationalization still has a bumpy road going forward.
This article appeared in the Hong Kong Economic Journal on Feb. 3.
Translation by Julie Zhu
[Chinese version 中文版]
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