Asiamoney: what now for the RMB?

Asiamoney, February 2012

The rise and rise of the renminbi used to be considered a foregone conclusion. It was accepted that the Chinese currency would be worth a whole lot more were it not artificially pegged to the dollar, or otherwise restricted in its movements; that’s been the basis of years of objection from the US about unfairly priced Chinese exports.

But is it still true? After the RMB’s peg to the US dollar was tweaked, allowing modest gains, in June 2005, the currency settled into a steady pattern of about 5% growth per year – despite a two year period from 2008-10 when it was frozen – and until recently was widely expected to continue to appreciate in the same way. This is one of the key reasons the dim sum bond market has taken off as it has: investors have tended to factor in a near-guaranteed currency appreciation on top of whatever yield a bond pays.

But something has changed. Market expectations have become less certain, and most analysts have reduced their outlook for RMB appreciation against the dollar. Nomura’s Simon Flint has a base case of a less than 3% rise in 2012; HSBC’s Paul Mackel, head of Asia currency research, predicts around 3%, but with the potential for much worse, and with heightened volatility; Chua Hak Bin, head of emerging Asia economics at Bank of America Merrill Lynch, says he is “looking for a much weaker pace of appreciation for the RMB”; Citi’s Nadir Mahmud estimates 2-3%; and Deutsche Bank’s Linan Liu is looking at about 3.5% (in its offshore form at least – that’s another story, which we’ll return to).

Even the most strident supporters of the currency predict a slowing of growth. The RMB “is the only market which has maintained its fundamental strength through all the financial stresses of the last 12 months,” says Shankar Hari, head of FX for Asia ex-Japan at JP Morgan. “There will definitely be more volatility this year, but there is no structural change and the eventual trend will remain quite constant.” But he, too, expects a slowing of growth; his year-end call, for an exchange rate of 6.05 to the dollar, equates to about 4% appreciation.

There is even a view being considered – albeit unlikely – that the RMB could actually decline in value. “The most notable development for the RMB recently has been the almost persistent depreciation pressure the currency has been facing since the end of September,” notes Mackel at HSBC. Reserves have begun to show net outflows. “RMB depreciation is highly unlikely, but not impossible, should the US dollar suddenly be much stronger,” says Mackel.

[Subhead]China’s economy

So what’s changed? Flint thinks that “the slower pace of CNY appreciation reflects reduced economic incentives for change,” specifically referring to lower headline inflation pressure and lower growth, exacerbated by problems in Europe, the risk of a domestic hard landing, and even the critically important 18^th Party Congress, likely to take place in October.

Naturally, the biggest single influence on the currency will be the behaviour of the Chinese economy itself. Taking a view on this depends on whether one expects the soft or hard landing scenario to unfold. The more common view at the moment is for a decline in growth, but only to levels that would still look remarkable everywhere else in the world. China’s GDP growth fell from 9.1% in the third quarter of 2011 to 8.9% in the fourth, bringing full year growth to 9.2%. JP Morgan, for example, expects it to slow further to 7.6% year on year growth in the first quarter of 2012, which is a notable decline, but still above almost anywhere else in the world – even Indonesia, the darling of emerging market investment flows today.

“Our view is it’s going to be quite a soft landing,” says Adam Gilmour, Asia Pacific head of derivative and FX sales at Citi. “The budget deficit in 2011 was 1% of GDP. If you compare that to all of the western world – to pretty much everybody – it’s next to nothing. China’s a massive economy now, it has firepower, and if it wants to do something about it, it can. The probability of a hard landing is almost zero.”

That being the case, then the moderated appreciation outlook is much more likely for the currency than any decline; but equally, a strengthening US dollar will have a big impact on the cross-rate too. The dollar is enjoying a somewhat unlikely renaissance at the moment, as some reasonably bright economic numbers have been accompanied by enthusiastic flows into the dollar as a low-risk currency.

The exchange rate is not just about economic data and fund flows. From a more macropolitical perspective, Flint is also keeping an eye on what he sees as worsening Sino-US relations. He expects an acceleration of WTO cases against China, and believes RMB-related legislation could pass through the US Congress, probably without veto from President Obama. “Although the direct substantive impact of such a bill is likely to be small, its symbolic importance would be significant,” he says. “China will not wish to be perceived as accelerating CNY appreciation under duress.” There are other political issues that could conceivably have an impact on the currency ahead as well, such as relations with Taiwan and an expected visit by Chinese Vice President Xi Jinping to the US early this year.

While all of these factors have muddied the picture for RMB forecasts, there are still very few who think a decline against the dollar is realistic in the short term. “Depreciation is unlikely, in our opinion,” says Flint. “We believe that China will be wary of a number of risks which would militate against depreciation: domestic capital flight; being perceived as exporting their domestic economic strife; undermining efforts to internationalize the CNY, and being seen as provocative towards the US.”

[Subhead] Fair value

So is it possible to think of the RMB as representing fair value now? Mackel at HSBC now talks about the RMB being “close to an equilibrium valuation”, and logically, if a currency is moving less than the maximum that a ceiling permits, then one can argue it’s no longer valued in an artificial way.

But some think this is the wrong question. “I’m always surprised people talk about where the fair value of the RMB is,” says Ulrich Leuchtmann, managing director and head of FX research at Commerzbank. “People talk about some concept where they say the RMB should be there or there, and then the Chinese trade balance would be at some normal or long-term sustainable level. I don’t know how they get it.” Leuchtmann argues that Chinese economics around the exchange rate simply don’t work like the rest of the world. “We saw rising trade surpluses in times of RMB appreciation, we saw falling trade surpluses in times of RMB depreciation. The usual pattern simply does not apply.” And since the Chinese trade balance is apparently not sensitive to exchange rates, it makes it difficult to think in terms of fair value.

Leuchtmann instead finds other aspects interesting.  “It’s more important to realise the Chinese themselves are having more and more problems with the current exchange rate regime than the US does,” he says. “It means the Chinese have less ability to control inflation. A lot of the measures a central bank usually could apply to control inflation at the moment are needed to sterilise what they are doing in the FX market.” This, he argues, is one reason inflation has risen in China, “because the Chinese have lost the possibility to apply monetary policy as a central bank normally can do.” He expects a shift to a more flexible exchange rate regime much quicker than many others do. “Others think five or 10 years. I think something like two years. It’s in their interests to change this regime, though only gradually.”

He’s not the only one thinking this way. In January HSBC put out a report entitled: “FX regime under siege?”In a nutshell, this argued that the exchange rate regime was set up to handle persistent inflows, and was ill-suited to handle more volatile net flows of the type that has evolved since September. China’s FX regime, loosely defined, involves two stages: a daily mid-point fixing, around which the currency can trade; and large scale reserve accumulation. That, HSBC says, has allowed it to closely manage the currency, with the central bank – as the hoarder of these reserves – the main determinant of the supply and demand of FX. This has worked even during other brief periods of outflows, such as late 2008, but this time the PBOC seems to have had a little less power to keep control. That suggests China will have to evolve its FX regime – but how?

In the near-term, HSBC says, it can deploy FX reserves to counter US dollar demand and bring the spot price back in line; can allow the market to establish its own equilibrium; widen the trading band; or just continue to set the daily fix as they always have and ignore what the spot market is doing. “It is not yet clear how this situation will ultimately play out,” noted HSBC, thinking a combination of the first and last options was most likely. “One likely reason for the policy to have taken so long to respond is that the authorities have not faced such a situation before.”

[Subhead]Offshore

Complicating things further is the offshore RMB market, which continues to behave rather differently to the onshore. And if anything, it’s becoming more different all the time.

“CNH [offshore RMB] has completely gone full circle,” says Shankar at JP Morgan. “CNH-CNY was at a premium [in favour of CNH] to start with; now it’s a discount, with CNH depreciation.” The shift has been dramatic: CNH stood at a 2.3% premium to CNY in 2010, and a 1.9% discount by September 2011. He attributes this to a slowing growth of deposits and a large number of new dim sum bonds, so that supply has increased as liquidity has drained. It was a remarkable movement, noted by other analysts too. “Perhaps the most surprising development [in 2011] was the reversal in the CNH-CNY spot basis, and the two way volatility since,” says Linan Liu at Deutsche Bank.

That might suggest weakness in CNH, but the market grew considerably in 2011, both in terms of the dim sum bond market and the expansion of cross border trade settlement. “The offshore RMB market achieved impressive development milestones in 2011 in terms of the amount of trade settlement, the size of offshore liquidity pool, CNH FX trading volume and the size of the fixed income market,” says Liu.

Most expect further development of offshore RMB this year: further RMB FDI programmes (one was formally launched already, in November), greater use of RMB cross border trade settlement, the launch of the RMB QFII program, more trading partners in RMB cross currency swap arrangements (particularly with Asean countries) and more trading centres for offshore RMB bonds. Deutsche expects RMB150-200 billion in CNH bond issuance for RMB FDI purposes next year; RMB3.7 trillion of RMB trade settlement, a 67% year on year increase; daily CNH FX trading of US$3.5-4 billion, up from about US$2 billion today and just $500 million at the end of 2010; an offshore RMB deposit base of RMB1.5 trillion; and gross issuance of CNH bonds of RMB280 billion. It also expects CNH bond total returns of 7.4% in dollar terms: 3.9% of it the bonds, 3.5% the currency.

That’s all good for the future of the market, but spot price volatility between the two forms of the currency is expected to last at least for the first months of this year.

The differing performance of the two arms of the same currency is not necessarily such a bad thing; some are already finding ways to make money from it, and not just traders. “Onshore corporates and MNCs have become active in taking advantage of the differences in the onshore and offshore exchange rates recently,” says Liu. She says Chinese exporters, and companies with US dollar receipts generally, have started to shift more dollar sales to the offshore CNH market, while making dollar purchases onshore. Mark Burrough, head of FX product management in treasury services at JP Morgan, adds: “Use of the offshore forward market is becoming more prevalent, and growing. It opens opportunities for corporates in that space in terms of what tools they can use for hedging.”

And it is interesting to see how houses are advising their FX clients about the RMB now. Since nobody thinks the RMB is going to go straight up anymore, and since it will have this odd onshore-offshore difference, that clearly creates ideas for traders. Deutsche, for example, expects volatility of the dollar-yuan cross to rise, particularly since Premier Wen’s announcement in November that China will start to “increase the yuan’s flexibility in both directions”, a message reinforced by the People’s Bank of China in December. Thinking this through, Deutsche argues offshore NDFs will be more volatile than onshore spot, and thinks that further weakness in Chinese data will hit NDFs again, so is telling clients to go long CNY vols even while taking a short 1 year dollar/yuan position through NDFs or CNH.

It’s hard to find a consensus view among all this, but strategists tend to have a few things in common: they see continued RMB appreciation, but at a slower pace and with greater volatility; they expect the offshore RMB market to continue to grow, with the CNH-CNY spot continuing to move around; and they expect a soft landing for China, with attendant moderate consequences for the currency. But even the fact that there’s a debate to be had is significant: the days of unquestioned upward movement are gone.

BOX: SHANGHAI

In late January, China’s National Development and Reform Commission (NDRC) announced some significant ambitions for Shanghai and the Chinese currency. In a statement, it said it wanted Shanghai to become a global centre for innovation, pricing and clearing of RMB-denominated financial products by 2015, with a total transaction value of all financial markets – apart from foreign exchange – of RMB1 quadrillion, compared to RMB386.2 trillion in 2010.

The program, to take place within the timeframe of the 12^th Five-Year Plan (2011-2015), fits into the broader ambition to make Shanghai a key international financial centre by 2020.

“It’s a significant event,” says Zhang Zhi Ming, head of China research at HSBC. “The significance is firstly that it’s the NDRC’s number one directive of the year, which is normally reserved for the year’s most important initiative. Secondly, it gives a specific time for a specific target.” That is striking given that Shanghai today is in a period of poor performance in both equity and bond markets; such a clear timeline is a clear indication that China wants to drive Shanghai forward again. “They really need something else to help it grow,” Zhang says.

What will Shanghai do that it doesn’t already do today? The People’s Bank of China already set up an RMB clearing centre, Shanghai Clearing House, in 2009. “They have the hardware and infrastructure in place,” says Zhang. “What they don’t have is really a rate market. RMB interest rates are still regulated onshore. Shanghai has Shibor, but the role it plays is much less than, say, Libor for dollars, because of the way that interest rates are managed.”

That being the case, does the ambition for Shanghai suggest that we will see a greater openness in the currency itself, and the rates that govern it? There seems little point in making the announcement otherwise. “The exchange rate is fixed instead of market driven, and capital flows are very much restricted; those pieces are not in place,” says Zhang. “Maybe this will push these things to happen sooner.”

In particular, Zhang expects that by 2015, there will be greater two-way movement in the currency. “You can already see that it is no longer a one-way bet,” he says. “That will probably be further strengthened by then, so you can have depreciation as well as appreciation.” That makes the announcement about Shanghai more significant, because if one believes the RMB is going to continue relentlessly up, then it’s not such a big deal to be the pricing centre for the currency: you could do it with a calculator. “Two way volatility is very important,” Zhang says. “Only when that happens does Shanghai being the place that prices RMB become significant. Otherwise, it’s fixed anyway.”

It’s interesting to wonder what this means for Hong Kong. Most of what the statement talked about was onshore rather than offshore, but there was a reference to establishing a cross-border RMB investment and financing centre. Still, 2015 is only three years away, and Hong Kong’s march as an offshore centre will not be easily interrupted. “Hong Kong will still have a role,” says Zhang. “You will see a gradual increase in cross-border activity and Hong Kong will still have its status in that market, though the pricing role will migrate more to Shanghai.” If complete capital account convertibility took place by 2015, that might change things, but few are calling for anything that rapid, and that plays to Hong Kong’s strengths as the leading place for offshore capital flows.