Now vs 2015 – Déjà vu?

Persistent appreciation in the ten years to 2015 has led to a carry trade boom of buying yuan with dollar. The result was a gigantic accumulation of forex liabilities in tandem with currency mismatch, which is the difference between net international investment position and FX reserves in the chart shown below. And yet a 3% surprise devaluation in August 2015 deterred investors from holding their long-CNY, short-USD positions. Massive yuan selloff and the capital exodus during 2015-16 was mainly a result of the violent unwinding.

Today, CNY is no longer a one-way bet, thanks to the post-2015 market reforms. This distinction is important, because the absence of large carry positions and the resultant sharp fall in currency mismatch lower the risk of capital flight. Regulatory pitches on FX risk management also helped; about 30% of companies have hedged their exposure as of March, compared to as low as 4.6% in 2015. In 3Q 2015 alone, about one-thirds of unwinding were attributable to Chinese firms’ paydown of foreign currency debt due to a lack of proper hedging. By comparison, companies are now less exposed to FX risks, reducing the likelihood of panic dollar buying.

Meantime, China’s FX reserves has stayed firmly in the USD3tn+ terrain. Which is twice the nation’s short-term external debt and enough to cover over 13 months of goods and services imports.

Adding on top is the sizeable chunk of inflows absorbed by the banking system over 2020-21. Of the USD268bn net forex settlement conducted by banks in 2021, some USD147bn were bought by the PBOC. In other words, about USD121bn worth of “surplus” dollar were held by financial institutions. Ditto the Chinese Inc. and individuals, with the FX deposits exceeded USD1tn for the first time ever. Such war chest is a powerful buffer to stabilize the currency at times of high volatility.

Bottom line, PBOC has various tools at disposal should CNY depreciates too fast. Apart from conducting interventions in the spot market, we reckon the authority would also bolster the yuan by using FX derivatives. Without depleting reserves, PBOC could prop up the currency and unwind their positions when depreciation pressures abate.

Meanwhile steps could be taken to slow outflows and encourage inflows from Chinese firms, including raising the macro-prudential factor for companies’ cross-border finance (capabilities to borrow foreign currencies overseas). Other alternatives include a further reduction in the reserve requirement for foreign currencies and reintroduction of a counter-cyclical factor.

CNY forecasts revised

USD/CNY hit 6.60 on 28 April, five months ahead of our forecast. USD/CNY bottomed at 6.3093 on 28 February, shortly after Russia invaded Ukraine on 24 February. From here, the CNY went from being the strongest to the fourth weakest Emerging Asia (EMA) currency. As of 28 April, the CNY depreciated by 4.1% YTD to 6.6265 per USD, its weakest level since November 2020.

The domestic factors driving the CNY’s depreciation are intact. Unlike 2021, CNY will not be underpinned by the Chinese economy exceeding its official growth target. Our GDP growth forecast for 2022 is 4.8%, below the official 5.5% target set for 2022. The IMF is more bearish at 4.4%. Purchasing manager indices for manufacturing and services have turned negative in March and April for the first time since the Covid outbreak in March 2020. China’s economy faces multiple challenges, including its Covid Zero policy, a crackdown on tech and other private sectors, a real estate weighed by heavy debt and weak home sales.

Externally, USD/CNY has room to catch up to the USD’s global strength. The USD Index (DXY) has appreciated above the highest level since the Covid outbreak in March 2020. More importantly, the start of the Ukraine war on 24 February and the Fed hike cycle on 16 March ended the consolidation of the EMA currencies that started in mid-2021.

Two factors suggest further pressure on the EMA currencies, including the CNY. First, our chief economist expects the Fed Funds Rate to increase from 0.50% to 2.50% this year. Conversely, China has been easing monetary policy by lowering banks’ required reserve ratios and key interest rates. Capital outflows from monetary policy divergence could be inferred from three straight months of declines in China’s foreign reserves in 1Q22.

Second, a weaker global economic outlook is unfavourable for export-led EMA currencies. In April, the IMF downgraded its 2022 global growth outlook to 3.6% from 4.4%. During his May Day address, Singapore Prime Minister Lee Hsien Loong warned of a global recession within the next two years.  

Barring an unforeseen plunge in the DXY, we see scope for USD/CNY to play catch up to its EMA counterparts. Hence, we have lifted our 3Q22 forecast for USD/CNY to 6.85 from 6.60. If a global recession turns up, we do not discount USD/CNY extending and prolonging its ascent.

To read the full report, click here to Download the PDF.