RMB Hits a Speed Bump – For Now by Hayden Briscoe, AllianceBernstein
The notion that China’s currency, the renminbi (RMB), is on a long-term path of appreciation appears in question after its sharp decline since February. We think that the setback is only temporary—and that the currency will resume its climb in a few months.
Some investors have added exposure to China, expecting a reasonable proportion of their returns to come from the RMB’s steady appreciation. For them, events since February may have come as an unwelcome surprise. In that month, the People’s Bank of China (PBC) widened the band within which the currency traded against the US dollar from 1% to 2%.
Since then, the currency has depreciated by about 4%.
The decline seemed to reduce the potential returns that investors in RMB-denominated assets had hoped to make, and it raised questions about capital flows. To what extent did it signal that international investors were losing faith in China, given the country’s well-publicized economic challenges? Would the currency have to fall even further to stimulate China’s export sector and revive overall growth?
We believe that concerns are overdone for three reasons—currency fundamentals, history and government policy. The widening of the trading band was deliberate policy: one of the PBC’s objectives was to reduce the flows of speculative capital, or “hot money,” into the economy, much of it attracted by the prospect of a rising RMB.
Early indications are that the PBC has succeeded. We estimate inflows of hot money into China’s foreign exchange (FX) reserves in January and February to be US$38 billion and US$25 billion respectively, followed by outflows of US$30 billion in March—the month after the policy took effect. The result was US$33 billion of net first-quarter hot-money inflows. Overall, FX reserves increased by a massive US$129 billion during the quarter (Display 1). Cross-border capital flows are fundamental factors in determining a currency’s valuation; on this basis, the RMB appears well supported.
How sensitive is the RMB to changes in the current account? As the red line in Display 1 shows, the last time China’s current account experienced net outflows was in the second quarter of 2012. Compare that with the secular appreciation for the RMB shown in Display 2: while the currency dipped in the latter part of 2012, it still managed to gain 1% against the US dollar for the year before reverting to trend and rising 3% during 2013.
What factors today might suggest that the RMB should fall further? Very few, in our view. In fact, there are both fundamental support, from continuing current account growth, and technical support. Last month, for example, the World Bank’s International Comparison Program—which compares countries’ gross domestic products and estimates their purchasing power parities (PPPs)—released its latest report. Based on 2011 data, the report revised downward the prices of nontraded goods and services in China and re-estimated China’s PPP. The result was a forecast that China will overtake the US as the world’s largest economy (in PPP terms) by the end of this year. This assessment left room for further currency appreciation.
RMB Is a Policy Tool
China has experienced significant changes since 2012, not least a slowdown in economic growth (as reflected in the relatively low first-quarter trade balance shown in Display 1). Some commentators have suggested that the Chinese authorities could respond by allowing the RMB to fall further to assist an export-led recovery. We disagree, for three reasons.
First, such a move would be politically fraught. It would result in China once again exporting deflation, as it did during its heyday as the world’s factory—only this time with far greater potential consequences, given the fragile nature of the global recovery. At the very least, it would risk confrontation with the US—a frequent critic of China’s currency management. The US Department of the Treasury, for example, sharply criticized the February devaluation and wants to see a much higher RMB.
Second, it would run counter to the policy of President Xi Jinping and Premier Li Keqiang to internationalize the RMB. The administration is firmly committed to this process, which we think could lead to the RMB becoming a regional reserve currency far more quickly than most people expect. Creating and maintaining trust in the currency is essential to this project and would easily be undermined by large and unpredictable changes in the RMB’s valuation.
Third, the RMB is an instrument of policy—a tool the government uses to achieve its ends. China’s overriding policy objective is to preserve social order by securing more diverse and sustainable economic growth, in which domestic consumption plays a larger role alongside trade. It’s pursuing the goal through reforms that will give market forces freer rein. The internationalization of the RMB is an important part of the strategy, and the widening of its trading band in February was a small but important maneuver in the overall campaign.
The RMB quickly recovered from the depreciation that followed the previous widening of the trading band. Display 3, for example, shows a rapid return to appreciation after the band was widened from 0.5% to 1% in April 2012. Our analysis suggests that the currency could be back on its long-term appreciation curve of 4%?5% a year by this time next year.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Hayden Briscoe is Director of Asia-Pacific Fixed Income at AllianceBernstein Holding LP (NYSE:AB).