From Chen Long of Evergreen GaveKal
Renminbi Limbo: How Low Can It Go?
As we argued last week, the recent depreciation of the Chinese currency was engineered by the central bank—not as a competitive devaluation, but rather to rout speculators making one-way bets on renminbi appreciation. The People’s Bank of China (PBC) acted after January saw roughly US$73bn in net capital inflows, the biggest deluge of inward flows in 12 months. The question now, after a 1.4%fall in the renminbi in 10 trading days (a bigger fall, admittedly, than we anticipated), is just how far will the PBC go to prove its point? In our view, not much farther, because Beijing recognizes the risk of sparking a broader loss of confidence.
First, a quick reminder of how Chinese currency management works. Since 2005, the PBC has been managing the renminbi (RMB) gradually upward against the US dollar, at an annual rate of about 5% a year through the end of 2011 (except for a hiatus during the global financial crisis), and a slower pace of around 2-3% since 2012. The RMB is allowed to trade 1% below or above a “central parity rate” which the PBC sets daily. From September 2012 until a week ago, the spot RMB rate continuously traded above the parity rate— usually, quite close to the 1% limit. This limit-up trading reflected the view that the RMB was a one-way appreciation bet.
Two weeks ago, the PBC made an unusually large downward adjustment in its parity rate, and this triggered an even steeper selloff in the spot market. The cumulative weakening in PBC’s central parity has been 183 pips (from 6.1053 to 6.126), while the spot market adjustment has been 850 pips (from 6.0645 to 6.1495, a decline of 1.4%). In 10 trading days the RMB has erased all its gains since last May, and the spot rate has started to trade below parity for the first time in almost 18 months (see chart on page two).
How much farther will the RMB fall? At the outer limit, perhaps as low as 6.24, but probably much less. The reasoning is as follows. Right now the spot market is trading 0.4% weaker than the central parity. So without any further move by PBC to weaken the parity, the limit is 6.18. A move below that would require PBC to adjust the parity further downward. The biggest-ever downward adjustment in the parity was 685 pips, in May 2012. If the PBC matches that move (by adjusting the current parity down another 500 pips), the RMB could fall to 6.24.
But we doubt the parity will move anywhere near that far. First, the PBC has already achieved its goal of punishing speculators, as shown by the spot rate trading below parity. Second, more aggressive depreciation risks a backlash from China’s trading partners who will complain about beggar-thy-neighbor tactics. Third, the depreciation drive carries costs. Beijing’s already massive foreign exchange reserves are building up as state banks have been ordered to purchase dollars. This creates unwanted liquidity in the domestic financial market, at a time when PBC wants to keep liquidity from growing too fast.
The final reason is the risk that a controlled depreciation could morph into uncontrolled capital outflows. Most emerging markets have experienced significant outflows since Ben Bernanke’s tapering hint last May, and China has not proven itself immune: it had outflows in the first three quarters of 2012 (between QE2 and 3) and then again briefly last summer. China’s economic fundamentals are weaker now than in 2012. While it is true that Chinese authorities have enough ammunition to prevent a Turkeystyle meltdown (capital controls and US$3.7 trillion in reserves), sustained outflows can make management of domestic liquidity much more difficult (see [China] Who’s Afraid Of Capital Outflows). At the end of the day, the currency moves are about giving the PBC more room to maneuver in the domestic market, and that aim has been largely achieved.