China: what to expect for CNY?

In the past 10 business days (Jan 16-29), CNY depreciated against USD by 1%, moving close to theceiling of the daily trading band. Such volatility is not unprecedented for CNY (CNY saw similarmovements in early-2014 and end-2014, see chart 1), but it has generated speculation whether CNYwill turn into a depreciation trend. In particular, investors wonder whether the PBOC will widen thetrading band, or let CNY depreciate against USD significantly in the near term.

    A short answer is no. By contrast, our strategist Ying Gu recommend the current situation providesan opportunity to tactically short USD-CNH (“China FX: upside risk in USD/CNH spot will becapped by stable band ceiling. Go short 1M USD-CNH”, January 8).

    Admittedly, there is strong argument behind the call for CNY depreciation against USD. In 2H14,CNY remained flat against USD, but appreciated by 8.1% in REER (real effective exchange rate)term as USD strengthened. Looking ahead, our global forecast calls for a strong USD against othermajor currencies, driven by the divergence of monetary policy between major advanced economies.

    Maintaining stable USD/CNY implies further upward pressure on traded-weighted CNY, whichtends to hurt exports and growth outlook.

    However, we think the room for further CNY depreciation is limited in the near term. Stablecurrency with two-side volatility remains a preferred option for the PBOC, and the likelihood ofband widening is small in the near term.

    First, the impact of currency depreciation on the export sector might be limited. To start with, smalldepreciation will only have limited impact. Large CNY depreciation will help exports, but in realityit will be difficult to implement given that China’s trade surplus reached new historical highs in2H14, and current account surplus widened. It may also lead to competitive devaluation from othercountries, which will compromise the initial purpose of currency depreciation.

    Second, the policymaker is concerned about the risk of intensified capital outflows. Latest data andour calculation suggest that China observed large capital outflows in 2H14 (second chart). Adjustingfor trade surplus, direct investment and changes in FX deposits by corporate and households, the“hot money” outflow was estimated at $49.4bn and $108.9bn in 3Q14 and 4Q14, respectively. Thiswas perhaps related to corporate repaying foreign debt or hedging FX position accumulated inprevious years (note that Chinese companies have accumulated large FX debt in recent years, withBIS statistics suggesting foreign claims on China rose to US$1.29 trillion by 2Q14, and most of thedebt being unhedged and hence exposed to currency risk). Such capital outflow has not become aconcern by far (to some extent it is welcomed by the PBOC to divert foreign asset holding from thecentral bank to the private sector). However, if CNY depreciates significantly, capital outflows mayintensify further and become a big concern.

    Third, as the Chinese government pushes for progress on RMB internationalization, amid ongoingdiscussion of RMB to be included in SDR, the authorities are unlikely to be keen to push for CNYdepreciation, as it may hamper the progress on RMB internationalization.

    Overall, with the combination of widening current account surplus on the one hand, and thestrengthening USD trend on the other, as well as the medium-term, strategic plan to push for RMBinternationalization, we believe the most likely scenario in 2015 is for the CNY to trade within range(at between 6.10 and 6.30 against the USD), and stay unchanged at 6.15 at end-2015.

    Beside, in our view the likelihood of band widening is low in the near term. From a technicalperspective, band widening happened (in April 2012 and March 2014) when spot move close to midprices (third chart). This is not the case now.

    Alternatively, the proposal of shifting towards a basket approach sounds economically viable; butimplementation is difficult to avoid the above-mentioned risk (capital outflow; competitivedevaluation). Indeed, decision cost is high. Such a policy move may require additional triggers (suchas significant depreciation of other EM countries), but China is unlikely to be the first mover.