On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.

Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks. In fact, the RMB has strengthened recently which seems to have caught many off guard. We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks. My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month. In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see. This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens. The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD. Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen. The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks. Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to. As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants. For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months. Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive. Before August 11, when there was no expectation of future weakening, the spread was large. Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening. Spreads on various futures products remain tight even as markets continue to expect longer term depreciation. Traders continue to report difficulty executing trades at posted prices for various products. Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation. Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate. As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation. It is worth noting that the RMB outflows have slowed, but still continue. Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed. However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock. The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.