Whither renminbi?

With China and the US in different phases of the business cycle, a large interest rate differential has opened up in favour of the US. This is sucking capital out of China and re-igniting questions about the sustainability of the current exchange rate arrangement – a nominally floating exchange rate that is so heavily managed that it shares characteristics with a US dollar peg.

To stem the impact of capital outflows on the exchange rate, the Chinese authorities have spent $175bn of their FX reserves since September 2022,¹ including quasi-reserves held by state banks. They have also consistently fixed the Chinese renminbi at a stronger level than that of spot trading during the second half of the year, with the gap exceeding that observed in 2015, the other episode of intense exchange rate pressure.

As a result of these efforts the renminbi has weakened just 5% against the US dollar this year.²

Chinese pressure points

To see what is at stake, we should remember that China printed large amounts of money following the global financial crisis without a commensurate increase in FX reserves. A closed capital account ensures that the money stays in China, but when interest rates diverge as much as they do, pressures build.

Currencies have historically depreciated by 50% when currency pegs break,³ and while China does not have a firm peg, risks of discontinuities are on the rise.

The good news is that so far foreigners are taking their money out, not the Chinese, and there is much less money that can leave this way. Equities and bonds held by foreigners as well as loans extended by foreigners add up to $3trn, less than the $3.3trn in official FX reserves.⁴

Gas in the tank

The IMF has a broader concept when it assesses reserve adequacy. Specifically, reserves need to cover maximum capital outflows – both by foreigners and residents – observed in other countries with closed capital accounts during periods of stress.

The IMF finds that $3.1trn of reserves are sufficient to withstand such pressures, again less than the $3.3trn in official FX reserves.⁵

On top of that, China could deploy $1.1trn of foreign assets held by state banks and $0.5trn of foreign assets held by China’s sovereign wealth fund CIC (not shown).⁶ Not all these assets may be liquid, but the majority should be.

What is the likely path of the renminbi from here? We believe that the authorities will defend the current level of 7.3 renminbi per US dollar. This is because they do not want Chinese residents to join the foreign capital exodus, which they might if they see the currency slide further. Buffeting the depreciation in that scenario would be much more costly in terms of lost FX reserves.

In our view, the authorities are likely to continue with a multi-pronged strategy to stabilise the currency:

1. Signalling through stronger fixing and verbal interventions
2. FX intervention
3. Tightening of capital controls

The latter could entail repatriation requirements for export proceeds, tightening of profit repatriation rules or simply red tape for renminbi-to-FX conversions.

How we put this into practice

What are the investment implications? We believe external pressures constrain the magnitude of monetary stimulus the authorities can administer – one reason we are less bullish on China than consensus.

Second, we don’t expect a large deflationary shock to the global economy that a steep depreciation of the renminbi would entail.

Hence, we are comfortable holding a long Chilean peso position which could suffer in the event of a major Chinese shock. We are also comfortable holding a long Taiwan dollar position, a currency closely correlated with the renminbi.

Sources

1. Macrobond and LGIM calculations as at 13 November 2023. Past performance is not a guide to the future.

2. Macrobond as at 13 November 2023.

3. ibid.

4. ibid.

5. ibid.

6. JPMorgan report China: dollarization of overseas financial assets published 31 October 2023.