From policy target to adjustment mechanism
Having outperformed its major trade partners in the first quarter of this year, the renminbi has fallen 10% vs. the US dollar and 6% in trade-weighted terms since then. With trade tensions remaining elevated and the economy continuing to decelerate, China has displayed increased flexibility, allowing financial conditions to adjust in order to prevent growth slowing further and pressuring local asset prices.
We believe the unprecedentedly high correlation of the currency to rate spreads reflects China’s stated goal of a gradual transition to a market- based mechanism to determine the renminbi’s value. Earlier this year, active domestic policies fostering a rebalancing towards consumption had already prompted a gradual erosion of the current account surplus. We believe that ongoing trade tensions compounded by an expansionary fiscal policy stance will help to accelerate China’s transition to a modestly negative current account deficit, warranting further currency weakness.
Is official tolerance plausible?
As a further recalibration of economic policy support will likely be required to cushion growth, we expect depreciation forces to remain in place through the 7.0 USDCNY level, with limited implications for global markets. That said, the Chinese authorities are likely to prevent a rapid speculative-positioning led decline in the renminbi through supportive policy signals and actions.
Unlike previous episodes of currency stress, the ability of the Chinese authorities to further restrict unidentified capital outflows and investment abroad is likely to ensure modest pressure on the balance of payments and therefore limited reserve attrition. With stronger controls in place, policymakers have gained the ability to signal their stance and allow locals to adjust their foreign exchange (FX) hedging as necessary while avoiding outsized currency-related confidence shocks.
Outbound portfolio flow remains a risk, with increasingly positive rate differentials on competing offshore assets, but ongoing deregulations facilitating foreign investment into Chinese assets at cheapened valuations will likely act as a backstop. Low hedging costs, well-aligned to the PBOC’s accommodative policy stance, have so far supported net foreign inflows into the domestic bond market despite the negative currency performance. Ultimately, we expect that the greater flexibility in managing the renminbi is likely to reduce hard landing risks and hence naturally cap downside currency risks over the medium term.
USD–CNY MOVING IN LINE WITH RATE DIFFERENTIAL
US less China 2-year swap spread (LHS) USDCNY (RHS)
Source: Bloomberg, J.P. Morgan Asset Management.
Risks to the blueprint
While China’s cyclical slowdown and policy divergence are central to expectations for further renminbi underperformance over the coming months, this view is strongly premised on a continuation of currency fundamentals driving market price action.
A conservative shift in PBOC currency management against a backdrop of consensus underweight positioning may act as a setback to our baseline view. Similarly, given the importance of Chinese trade for the major global economies, any rapid negative move in the renminbi may trigger a backlash, particularly amid already-heightened trade frictions. In addition, an earlier-than-expected end to the Federal Reserve’s tightening cycle in the US would remove the favourable rate differential support for the US dollar. Furthermore, as Chinese assets claim a rising share in reserve managers’ allocations and in global indices, and as the renminbi’s usage in international trade transactions increases, the Chinese currency’s relative performance should also improve over the medium term. An intensification of the US administration’s drive to use the dollar as a coercion measure in geopolitical negotiations may well accelerate this trend.