Since the beginning of this year, with the expectation the Federal Reserve would raise interest rates and the narrowing interest rate gap between China and the United States, the Chinese yuan (renminbi, RMB) does not fluctuate much despite some range of shocks. After the Lunar New Year holiday in February, the RMB performs strongly against the U.S. Dollar. On February 16, the exchange rate was quoted at RMB 6.3463 per Dollar, an increase of 142 basis points, and returned to below 6.35. At 16:30 that day, the onshore RMB exchange rate was closed at 6.3353, and the offshore RMB also returned to a level below 6.34. With the tightening of Fed's policy and the changes in the international geopolitical, the international capital market became panicky and unstable. Yet, the RMB exchange rate performed quite surprisingly well as it did not fluctuate much. The difference between the market patterns and the expectations is indeed puzzling. This leads to some discussion over the basic framework on the pricing and valuation of the RMB exchange rate.
Figure: USD/RMB exchange rate trend in the past four years
Source: Sina Finance
Markets view that economic stability and enormous market potential are among the main factors supporting the RMB exchange rate. The stable RMB reflects the firmness in the Chinese economy, which turns to become one main underpinning fundamentals in the region. Some researchers believe that the relevant Chinese authorities should not be too anxious about the impacts of the Fed's policy of raising interest rates, instead they need to focus more on the Chinese-based monetary and exchange rate policies. On the other hand, some market institutions are concerned that the RMB exchange rate might depreciate in the second half of the year under the policy changes of the Fed, bringing an impact on the capital market and the real economy.
According to the researchers at ANBOUND, the "abnormal" performance of the RMB exchange rate in the post-pandemic period does not deviate beyond its acceptable range. The current relative strength of the RMB exchange rate relates much with the pandemic, which is a special manifestation of the abnormal state. At present, the challenges of China's economy are not reflected in the RMB exchange rate. As the world recovers from the pandemic, economic activities will return to normal. With the restoration in supply chains, production shifts, along with the more apparent challenges in the Chinese economy, the RMB exchange rate will then be adjusted.
When the pandemic first erupted in 2020, the RMB exchange rate depreciated sharply amid the turbulent global capital markets and tight dollar liquidity. However, as the pandemic in China becomes under control, along with the easing policies among global central banks, it has gradually recovered. Two factors, namely fundamental factor and liquidity factors contribute to this. Since last year, during the early stage of the rapid economic recovery of major economies such as the United States and Europe, the fluctuation in the exchange rate of RMB against the U.S. dollar in the post-pandemic period shows that the RMB exchange rate was weak. While the global supply chain continues to weaken during the pandemic, under the circumstances of rising global inflation and economic growth, the RMB exchange rate became relatively strong. In particular, the continual growth of exports and cross-border capital inflow had caused the RMB exchange rate more resilient. Therefore, when China's economic growth slowed down in the second half of the year, the RMB exchange rate did not adjust much accordingly.
Consequently, despite the relatively weak fundamental in China's economy this year, export growth and capital flow still contribute to supporting the RMB exchange rate in the short run. Given the continual impacts of the pandemic on the supply and industrial chains, the production capacity and supply chain advantages in the Chinese manufacturing sector continue to stimulate foreign trade and attract direct investment. In recent months, the rise in foreign exchange settlement brought by trade balances, which has continued to increase the central bank's foreign exchange holdings, also strengthens the RMB exchange rate. Under the circumstance of excessive U.S. dollar liquidity and rising inflation, China is still an ideal international capital market for risk diversification, and international capital, therefore, continues to flow into China. According to the Bloomberg China Fixed Income Index Monthly Report, the Chinese government bonds have a total return of 874 basis points in 2021, while U.S. Treasuries lose 232 basis points. The Monthly Report believes that after outperforming the U.S. Treasuries in 2021, the Chinese Treasuries might outperform again in 2022. It is because even if the Fed begins to raise interest rates, the Chinese central bank is unlikely to tighten monetary policy. With the U.S. inflation level remaining high and the negative U.S. real interest rate, the RMB assets remains attractive.
However, looking at the long-term pattern, the RMB exchange rate still poses a great risk. Particularly, as more countries have gradually eased the prevention and control restrictions and return to normal, the recovery in production and supply chains might adversely affect China's export trade. After the Fed raises interest rates, a long-term fall back in inflation and the narrowing interest rate gap between China and the United States will then put pressure on capital inflows. ANBOUND has previously pointed out that given the strong position of the U.S. dollar, its increased volatility would always produce a direct or indirect impact on the Chinese economy. In this regard, China should not be too optimistic about the consequences of the monetary policy divergence between itself and the U.S. From the perspective of long-term fundamentals, as the rapid Chinese economic growth has gradually declined in the past years, yet the RMB exchange rate has been rising all the time, this distortion, if continues, might bring a large shock to the country's economy.
Albeit China's central bank putting assuring exchange rate stability as one of its main tasks in monetary policy, this is not the equivalent of keeping the exchange rate unchanged, but to confirm its equilibrium level with actual support and guide the exchange rate market to form rational expectations. ANBOUND has always emphasized the importance of keeping the RMB exchange rate stable so as to sustain the Chinese economy. In the long run, a sober and rational judgment on the changes in the RMB exchange rate is necessary to prevent irreparable losses caused by blind optimism.
Final analysis conclusion:
Although the RMB exchange rate remains strong in the short run, this in fact happens under internal and external supports, and it is an abnormal state caused by the COVID-19 pandemic. With the global economic recovery and central banks around the globe tightening their policies, the RMB exchange rate could very well face long-term impact.
