The sustained rise and rapid retracement of the offshore RMB exchange rate has triggered a high degree of market concern. We believe that although there are repetitions in the direction of short-term RMB exchange rate fluctuations and the expansion of exchange rate flexibility, the space for long-term appreciation has just opened. It is advisable to prepare for a long-term strategy, both at the national strategic level and at the asset allocation level for business operations, trade and investors.
Indiscriminate issuance reduces the purchasing power parity of the US dollar and the RMB exchange rate appreciates in the long term
In the case of relatively stable economic growth rate and labor productivity, the main influence on purchasing power parity is the change of price indices of the two countries, and the difference between the change of two price indices is essentially determined by the comparison of currency issuance of the two countries. In the case of a determined aggregate supply, the absolute purchasing power of a currency with a faster increase in currency issuance will decrease rapidly and the exchange rate will depreciate accordingly, while the absolute purchasing power of a currency with a slower increase in currency issuance will decrease more slowly and the exchange rate will appreciate.
From the perspective of the expansion rate of the balance sheet of the Federal Reserve and the People’s Bank of China, the fact that the dollar supply is increasing much faster than the RMB has already taken shape and cannot be reversed in the short term. From early 2020 to early June 2021, the Fed’s balance sheet expanded by 89.6%, while the PBoC’s balance sheet expanded by only 2.3% from January 2020 to April 2021. The change in the absolute purchasing power parity of the two currencies is the most important reason for the appreciation of the RMB against the USD.
After the Biden administration took office, it proposed a $1.9 trillion third round of new crown bailout bill and a $2.35 trillion infrastructure plan. The former has now been passed by Congress, while the latter is undergoing a fierce bipartisan game, making it difficult to scale down the dollar’s issuance, and the dollar’s purchasing power parity will fall.
Short-term RMB exchange rate flexibility expands
The main factors currently determining the short-term trend of the RMB exchange rate are, firstly, the direction of monetary policy changes by the Chinese central bank, its policies, operations and expected changes to stabilize the RMB exchange rate; secondly, the expectations of the Federal Reserve’s monetary policy; and thirdly, the marginal changes in the current account surplus.
The central bank’s monetary policy is the main factor affecting the short-term direction of the exchange rate. From the recent data released by the People’s Bank of China, the growth rate of social financing scale stock has been decreasing month by month, from 13.3% in February to 12.3% in March, 11.7%% in April and 11% in May, and non-standard loans such as entrusted loans and trust loans have been declining rapidly. Central Bank Governor Yi Gang also said recently that “monetary policy should pay attention to the impact of structural changes on prices” and “the pressure of both inflation and deflation from all sides should not be taken lightly.”
The central bank’s attitude toward the exchange rate and related policies and market operations often have a more direct impact on the trend of the exchange rate of its own currency, especially the Chinese central bank, which can also directly influence the supply and demand of the yuan and other currencies through some guidance measures or open market operations. For example, on May 31, the Chinese central bank decided to raise the reserve requirement ratio for foreign exchange deposits of financial institutions by 2 percentage points from June 15, i.e., the reserve requirement ratio for foreign exchange deposits was raised from the current 5% to 7%. From the above timing and magnitude of the central bank’s adjustment of the foreign exchange deposit reserve ratio, it is clear that the PBoC does not support the short-term appreciation of the RMB, which is too large and unilateral in the short term. The central bank is expected to continue to guide the two-way fluctuation of the RMB exchange rate through a variety of policy, market and expectation-led instruments, and the flexibility of fluctuation will gradually expand.
Specifically, the RMB/USD exchange rate will naturally be influenced by the Fed’s policy. At present, the Fed’s focus is still on economic recovery rather than inflation: the U.S. CPI has risen to 5% in May and the core CPI has risen to 3.8%. Although the Fed is still intoxicated by the lure of growth and employment brought by inflation, saying that inflation is temporary, future monetary contraction is expected to have formed, which is one of the reasons contributing to the short-term pullback of the RMB against the dollar.
Another important factor affecting the RMB exchange rate is the marginal change in the current account surplus, which represents the state of demand for the domestic currency arising from purchases of domestic goods and services. China’s long-standing current account surplus, although it began to decline after 2015, was pushed up by the instability of global supply chains due to the epidemic shock, which pushed up demand for Chinese products and led to a renewed expansion of the current account surplus in 2020, which was an important reason for the higher RMB exchange rate in the early period. However, with the gradual spread of vaccination in developed countries, the epidemic will gradually be controlled, the supply of these countries will gradually recover, and the dependence on China’s exports will be reduced, and China’s trade surplus has a tendency to narrow. In May, in dollar terms, the year-on-year growth rate of China’s exports slipped to 27.9% from 32.3% in the previous month, and the two-year compound growth rate slipped to 11.1% from 16.8% in the previous month. And in terms of chain rate, exports grew at 0.0% in May, and the marginal change in the current account surplus growth rate was less supportive of RMB appreciation.
Capital account and RMB internationalization help long-term appreciation
From the perspective of the capital account, the current high level of domestic interest rates in China and the low and zero interest rate policies prevailing in Europe and the United States have formed an obvious interest rate differential, which constitutes a continuous attraction for the long-term capital account flows. The current real yield of 10-year treasury bonds between China and the U.S. maintains a difference of more than 3.8 percentage points, and various short-term arbitrage funds will also contribute to the appreciation of the RMB. In addition, sovereign wealth funds and index funds from various countries have increased their investment weights in the Chinese market and increased their investments in the Chinese stock market through QFII, Shanghai-Hong Kong Stock Exchange, Shenzhen-Hong Kong Stock Exchange and other channels of investment, which also boost the RMB appreciation momentum under the capital account. Direct investment (FDI) in China by multinational companies from various countries has also picked up since the epidemic has been under control.
In the medium to long term, the share of RMB as a reserve asset will steadily grow globally. More than 70 central banks or monetary authorities around the world have included RMB in their foreign exchange reserves, holding a total of US$217.67 billion in RMB reserves by the end of 2019, accounting for 1.95% of the total foreign exchange reserves in the indicated currency composition, already the fifth largest reserve currency in the world, and the global share of RMB as a reserve asset is expected to increase in the future.
RMB Appreciation Space Just Opened
In the longer term, changes in a country’s currency exchange rate are still determined by its economic growth rate and labor productivity growth rate. The rise of a major economic power and the internationalization of its currency is often accompanied by a long-term appreciation of the country’s currency exchange rate. For example, with the rise and continued prosperity of the U.S. economy, the exchange rate of the British pound against the U.S. dollar gradually changed from 1:4.86 in 1925 to 1:1.38 today, with the U.S. dollar appreciating nearly threefold; the long-term boom of the German economy after World War II prompted the Deutsche Mark to appreciate more than threefold against the U.S. dollar from its creation in the 1940s to the 1970s; and the Japanese yen, more familiar to Asians, appreciated more than threefold in the the mid-1970s and mid-to-late 1980s completed more than 300% appreciation in just two phases ……
If the Chinese economy can continue to grow faster relative to countries like Europe and the US, and the RMB is still in the process of internationalization, the appreciation of its exchange rate is actually just beginning. We predict that the RMB exchange rate will find a relatively stable equilibrium against the dollar at the level of 6:1 within a year, and the longer-term equilibrium should go above 5:1.
Although the short-term rapid appreciation will impact exports, the appreciation of the local currency is not entirely bad – the appreciation of the local currency is a necessary path for a large country’s economy to move from processing trade advantage to comprehensive international competitive advantage, which is conducive to the expansion of exports before appreciation and to the expansion of imports and outward investment after appreciation.
In the structure of processing trade-based exports, because exporters do not have pricing power, all the impacts caused by RMB appreciation are larger, but with the upgrading of China’s export industries, the technological content, brand prices and pricing power, the impact of RMB appreciation on exports tends to decrease.
In order to reduce the impact of RMB appreciation on exports in the long run, international settlement of RMB should continue to be expanded. If China’s exports are settled entirely in U.S. dollars, most of the lower profit margins from RMB appreciation will be borne by Chinese producers and exporters; conversely, if more international trade is settled in RMB, the impact of appreciation will inevitably be borne more by overseas importers, intermediaries and overseas consumers.
From 2012 to 2015, the amount of RMB settlement of China’s cross-border trade grew steadily, from 2.94 trillion to 7.23 trillion RMB, but after 2016 there was a shock, with only 4.29 trillion RMB in 2020; a similar pattern is seen in the amount of RMB foreign direct investment, which was only 30.44 billion RMB in 2012 and grew to 1.06 trillion RMB in 2016, but also shows a shocking pattern after 2017, amounting to 583.6 billion yuan in 2020. Therefore, in order to reduce the impact of the RMB in the long term or even on exports, more international trade should continue to be promoted to be settled in RMB. Currently, it is a good time to expand the international settlement and use of the RMB as the Federal Reserve’s oversized balance sheet expansion under the impact of the epidemic has led to a decline in the credit of the US dollar.
Overall, because of the decline in long-term purchasing power parity of the U.S. dollar caused by the unprecedented U.S. monetary abuse and the increase in long-term purchasing power parity of the RMB brought by China’s economic growth and labor productivity gains, it is determined that the RMB will maintain a long-term appreciation trend against the U.S. dollar. Although the rapid short-term appreciation of the RMB exchange rate has been replaced by two-way fluctuations in the RMB exchange rate, the expansion of short-term exchange rate flexibility is merely a prelude to further appreciation. To rationally respond to the trend appreciation of the RMB, the national level should continue to vigorously promote the international settlement of the RMB, and import and export enterprises and investors should also make a comprehensive response in terms of production, trade and asset allocation.