With little sign of improved economic fundamentals, rapid currency appreciation is a potentially dangerous development.
On October 26, the renminbi's spot exchange rate against the US
dollar reached the upper limit of its floating range for the second
consecutive trading day. The rise began when the trading band for the
renminbi's dollar exchange rate was widened to ±1 per cent and has now
reached an all-time high since 1994's currency reform. With little sign
of improved economic fundamentals, rapid currency appreciation is a
potentially dangerous development for China - in part owing to the risk
of an abrupt and painful reversal.
The renminbi's rise over the past month can be attributed to greater
global liquidity since the start of the third quarter, as policymakers
have responded to the eurozone's sovereign-debt crisis and stagnating
output. Indeed, according to Morgan Stanley,
monetary authorities in 16 of the 33 countries that it follows -
including seven of 10 advanced-country central banks and nine of 23
central banks in emerging markets - have either cut their benchmark
interest rate or lowered reserve requirements.
After two rounds of quantitative easing (QE), the balance sheets of
the European Central Bank and the United States Federal Reserve have
grown to €3.2 trillion ($4.1 trillion) and $2.9 trillion, respectively.
The ECB's new outright monetary transactions (OMT) programme in
secondary sovereign-bond markets, and the Fed's open-ended "QE3"
continue this trend, while the Bank of Japan has expanded its
asset-purchase programme for the eighth time.
The spillover from the developed countries' latest round of QE is
beginning to show up in emerging markets, where nearly a year of
short-term capital outflows has given way to a new wave of short-term
inflows. With US domestic bond yields continuing to fall and US equities
reaching an upper price limit, owing to the real economy's sluggish
recovery, more money is expected to flow to commodity markets and
higher-yielding emerging countries. Given China's adherence to a stable
monetary policy, the renminbi has become a more attractive asset to hold
The spillover from the developed countries' latest round of QE is
beginning to show up in emerging markets, where nearly a year of
short-term capital outflows has given way to a new wave of short-term
inflows. With US domestic bond yields continuing to fall and US equities
reaching an upper price limit, owing to the real economy's sluggish
recovery, more money is expected to flow to commodity markets and
higher-yielding emerging countries. Given China's adherence to a stable
monetary policy, the renminbi has become a more attractive asset to
hold.
Indeed, as the renminbi strengthened over the last month, the
People's Bank of China did not intervene strongly to repurchase dollars
from commercial banks - a decision rarely seen in recent years. This
indicates that the renminbi's appreciation was driven mainly by
short-term arbitrage by outside funds.
Another reason for the appreciation is the renminbi's peg to the
dollar, which has fluctuated increasingly widely since October 2011. As a
result, while the renminbi performed poorly against the dollar in the
first half of this year (even depreciating temporarily), America's
year-end "fiscal cliff", together with QE3, has weakened the dollar
since the start of the third quarter, with the exchange rate falling
back to its level at the start of this year.
Enforcing capital controls
But there is still a need to be vigilant. While the onshore and
offshore renminbi markets remain decoupled, the start of renminbi
settlement under the trade account enables Hong Kong's offshore renminbi
(CNH) currency market to co-exist with the onshore (CNY) market,
leaving significant room for arbitrage. Given that the renminbi's real
and expected rates of return are higher than the real rate of return of
other currencies, it has become a positive carry against foreign
currencies, reinforcing the tendency to hold assets in renminbi and
liabilities in foreign currencies.
Because China is still enforcing capital controls, it is not easy for
foreign investors to put their money into the CNY market. Therefore,
most short-term foreign inflows have detoured through the CNH
market. Indeed, the Hong Kong Monetary Authority has had to inject
liquidity into its banking system four times in recent months - more
than HK$14.4bn - to stabilise the Hong Kong dollar's exchange rate,
which clearly indicates that the international hot money flowing in is
actually heading to the mainland.
Even with its recent strengthening, the renminbi is within a balanced
exchange-rate band that is appropriate to its foreign-trade balance;
still, China's economy could not bear sharp exchange-rate appreciation.
Fortunately, that seems unlikely. In fact, both the deliverable and
non-deliverable forward rates anticipate one-year renminbi depreciation
of 2.35 per cent and 1.75 per cent, respectively.
In fact, the renminbi could be shorted again - most likely via the
CNH renminbi market. In early December 2008, the worldwide crisis led to
a global capital outflow from China and the exchange rate of the
renminbi fell to its lowest limit four days in a row - a record since
the exchange-rate reform of July 2005. Then, beginning on November 30,
2011, the exchange rate approached the bottom of the trading band for
seven days, causing panic in the market. These events are not distant
memories.
After all, a currency's exchange rate is not determined only by
economic fundamentals. There will always be foreign short-term flows
that can increase a currency's volatility. Indeed, after its recent
sharp appreciation, the renminbi could turn out to be a prime target for
short sellers.
Zhang Monan is a fellow of the China Information Centre,
fellow of the China Foundation for International Studies, and a
researcher at the China Macroeconomic Research Platform.