What happens when positive developments run out on renminbi?

September 21, 2015 16:04
In the short term, big renminbi fluctuations are unlikely Xinhua

Global investors closely watch the renminbi exchange rate.

Nowadays, they look for signs of further weakness after its recent devaluation.

In the short term, however, big fluctuations are unlikely for a number of reasons.

First, President Xi Jinping is visiting the US soon; second, the national day holiday is coming.

These developments could reverse any downward trend in the renminbi.

But what happens next?

Three figures recently released by the Chinese central bank are quite insightful.

First, China’s foreign exchange reserves plunged by US$94 billion in August.

Second, its foreign assets including foreign exchange held by the Chinese central bank in its balance sheet have fallen by US$130 billion.

Third, foreign exchange held by the entire banking system dropped by US$115 billion.

Foreign exchange outflows could reach a record of US$178 billion, if spot trading in August and open forward contracts are included.

Some state-owned banks and commercial lenders have used their own foreign exchange reserves to absorb part of the capital outflow.

Onshore banks transferred renminbi worth of US$38 billion last month, which means they sold the same amount net in the offshore market, accelerating capital flight.

In this case, offshore investors will be reluctant to hold offshore renminbi if the exchange rate does not stabilize, which could worsen the capital outflow.

The Chinese central bank will keep its hands off the currency market but it won’t allow the renminbi to depreciate sharply.

However, the redback may ease moderately in the coming years, if the US dollar continues to gain strength.

The continued strength of the US dollar depends on a planned interest rate hike by the Federal Reserve.

The Fed has very clear metrics for adjusting its monetary policy, such as employment and inflation.

At present, the unemployment rate is 5.1 percent, the lowest since the financial crisis began.

However, the labor force participation rate also dropped to 62.6 percent from 67.3 percent in early the 2000s.

The US labor market has been witnessing structural change.

In this case, the Fed must take into account other factors in assessing the job market.

In fact, some indicators including the ratio of unemployed workers to job openings and average time to fill jobs have returned to pre-crisis levels.

How about US inflation?

At the moment, headline CPI is only 0.2 percent but things change after we subtract energy and food prices.

The personal consumption expenditure price index (PCE) is 0.3 percent, higher than CPI, but core PCE is 1.2 percent.

If the US job market continues to recover, labor costs will increase, which in turn will drive consumption and nudge inflation closer to the 2 percent target. 

In that case, the Fed may normalize currency rates.

China faces various challenges in pushing economic reform apart from the currency issue.

Some say certain regional economies are struggling due to a lackluster private sector.

State-owned enterprises continue to dominate, but if SOE reform results in factory closures and mandatory merges, it could exert severe shocks to regional economies and people's livelihood.

This article appeared in the Hong Kong Economic Journal on Sept. 21.

Translation by Julie Zhu

[Chinese version中文版]

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Senior investment banker