Forming a view on exchange rates can be as daunting as deciding whether the frozen winged creature in the host’s kitchen is a turkey. If it looks, smells, feels, and tastes like a turkey, then it had better been a turkey. But if the host is Chinese, then the multi-factor approach may very well lead to a different conclusion, even on Thanksgiving in America!
Exchange rates tend to mean revert to correct for temporary imbalances in international trade. In addition, nascent trends may be cut short by the central bank for the sake of exchange rate stability. This is especially true in China, where stability is not only a political imperative but also an explicit monetary policy objective for the RMB.
Compared to G10 currencies, the RMB (weaker when the USD/CNY exchange rate goes up) is less tractable due to the non-independence between China’s State Council (equivalent to a government cabinet) and its central bank - People’s Bank of China (PBOC). This is further complicated by the current phase in Sino-US relations. Nonetheless, it is useful to form a medium-term view through a multi-factor approach called TEMMP (technicals, economics, markets that are relevant, monetary policy, politics). It may also be useful to estimate the tail risk on RMB if trade tensions escalate in the short-term. Finally, a bullish medium-term view on the RMB is formed based on scenario analysis.
The USD/CNY is limited by a 2% up or down limit against PBOC’s daily fixing rate, which is technically based on both the previous day’s closing rate and the China Foreign Exchange Trade System (CFETS) basket. The CFETS basket contains mostly non-dollar currencies, as the USD only weighs 22% in the basket. Therefore, when the USD moves one way, the CFETS basket tends to move the other way, as most non-USD currencies move in the opposite direction against the USD, a global benchmark. However, due to the addition of a counter-cyclical factor to the daily fixing rate since August 2018, the USD/CNY is not only tied to the movement of the USD but also to China’s monetary policy as implemented by the PBOC and directed by the State Council. Indeed, RMB internationalization depends on a stable RMB. Therefore, a trend in the RMB, if any, is likely to be gradual.
Since the short-term view of RMB is highly dependent on the potentially binary outcome of whether a planned 25% tariff on $200 BN of China’s exports to the US will be revoked 90 days from the Argentina G20 meeting that concluded on 12/1/2018, it may be more useful to estimate the tail risk than the central tendency. Of China’s $2,263 BN of annual exports in 2017, $430 BN, or 19% went to the US. In theory, the RMB has to depreciate approximately 5% (19%*25%) in order to offset the effect of 25% tariffs on all $430 BN, or even more due to trade elasticity and second-order effects on global growth. In practice, currency depreciation is not the best policy option, given its hindrance on RMB internationalization, and may derail financial account inflows from recent progress in global benchmark index inclusions. Therefore, the government has instead relied on fiscal policy tools such as corporate tax cuts and export tax rebates to prevent defaults and minimize layoffs.
In the medium-term, it is useful to perform scenario analysis on the two factors that raised question marks in the TEMMP analysis: US equity markets and Sino-US geopolitics. If the S&P does not enter a bear market, then there’s less incentive for the US to back down from further tariffs (top right scenario in 2-by-2 table). This causes the RMB to remain under pressure, as currently, from both a hawkish Fed and trade tensions, albeit mitigated by PBOC’s counter cyclical factor. However, if the S&P does enter a bear market, then there’s more incentive for the US to facilitate a deal (bottom left scenario in 2-by-2 table). This causes the RMB to rise, due to both a dovish Fed and normalizing Sino-US relations, albeit slowly due to a deleveraging economy. Since the S&P is more likely than not to enter a bear market by 2020, according to major market participants, RMB’s medium-term view is bullish.
In the relatively unstable scenarios of “S&P down and escalating tensions” (top left scenario in 2-by-2 table) or “S&P flat/up and subsiding tensions” (bottom right scenario in 2-by-2 table), conflicting effects on the RMB may just render it a lame frozen duck in the short term, waiting to be heated up!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.