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China’s renminbi is flirting with its lowest level against the dollar since the 2008 financial crisis and analysts expect its strength to be further tested in the coming weeks as the country’s rebound from the pandemic splutters.
The currency has dropped more than 5 per cent against the dollar this year, touching Rmb7.29 to the greenback and just shy of the high of Rmb7.32 hit last year, which marked the currency’s weakest level in more than 15 years.
The slide has pushed the central bank, the People’s Bank of China, to step up its defence of the currency in recent weeks.
But even if the PBoC manages to squeeze out those investors betting on further declines, policymakers in Beijing still face a battle to reinvigorate the renminbi. Here are the dynamics at play:
Why is the renminbi under pressure?
China’s economy has not rebounded as expected after being released from three years of pandemic lockdowns. Concerns over its performance would be more than enough on their own to encourage bets against the renminbi.
But those have been amplified by missed payments from struggling property developers and a mountain of obligations coming due on local government debt. To stimulate demand, China has been cutting its key interest rates.
The country’s sluggish economic growth and those rate cuts made in response have helped produce a yawning difference between the yields offered on Chinese government debt and those on its US counterparts.
US interest rates are at a 22-year high but as yet have not fully killed off inflation nor tipped the economy into recession. Those more attractive US rates have stoked outflows from China’s renminbi-denominated bond market.
Chinese exporters have also been converting a smaller share of their dollar earnings into renminbi, which analysts at Goldman Sachs said was “likely due to yield-seeking behaviour” as returns on dollar-denominated securities proved more lucrative than their local-currency counterparts.
The flagging economy and weakening exchange rate have put the People’s Bank of China in a delicate position.
“The PBoC is in a bit of a quandary, because it would probably need to make more interest rate cuts to stimulate demand, but that would cause the currency to weaken again,” said Mansoor Mohi-uddin, chief economist at the Bank of Singapore.
Why is Beijing concerned about capital flight?
While a weaker renminbi would bolster China’s exporters by making goods cheaper for other countries to buy, policymakers are wary of letting the currency fall too far and too quickly.
“From the central bank’s perspective, the real concern with a weak currency is capital flight,” said Adarsh Sinha, co-head of Asia foreign exchange and rates strategy at Bank of America.
The risk was starkly illustrated in 2015, when a one-off devaluation by the PBoC led to massive outflows and forced the central bank to burn through hundreds of billions of dollars to support the currency.
Afterwards, policymakers introduced more stringent capital controls to limit outflows. They also shifted their focus to managing the speed of moves in either direction, rather than defending an absolute level. That approach has proven effective during subsequent bouts of weakness, including US-China trade tensions in 2019 and the economic disruption stoked by last year’s Covid-19 lockdowns.
How is Beijing pushing back?
Analysts say China’s biggest problem is that it is running out of room to manoeuvre. “The PBoC is already utilising most of its tools for maintaining renminbi stability,” said Ken Cheung, chief Asia foreign exchange strategist at Mizuho Bank.
The central bank’s biggest weapon is its control over the currency’s onshore trading band. Every morning, before China’s domestic foreign exchange market opens, the PBoC sets a midpoint around which the renminbi is allowed to trade 2 per cent in either direction against the dollar. Usually the number is adjusted to reflect changing market expectations and overnight moves in the less-regulated offshore renminbi exchange rate.
But over the past month, the midpoint has been fixed at far higher levels than market predictions, with the central bank at one point fixing the rate a record 0.1 percentage point stronger than markets expected — a clear warning to speculators betting against the currency.
State-run Chinese banks are helping to enforce this warning on the PBoC’s behalf, hoovering up renminbi and selling dollars in the onshore market. They are also doing the same in the offshore market to ensure that rate does not stray too far from where the market closed in China.
And, in a sign of how uncomfortable policymakers are with the pace of depreciation, state lenders have also been squeezing liquidity in the offshore market for renminbi forwards for the first time since 2018.
The lenders have been selling dollars and buying renminbi in the offshore spot market while buying dollars and selling renminbi in the market for short-term currency forwards. This tactic makes it more expensive for currency traders in Hong Kong, London and New York to short the currency.
One measure Chinese authorities have not yet redeployed is informal limits on foreign exchange transactions in the country’s interbank market. Those were lifted last September in the face of surging outflows from renminbi bonds, driven chiefly by global investors dumping Chinese government debt in favour of higher-yielding US Treasuries.
How low could the exchange rate go?
Analysts are lowering their forecasts for the currency’s dollar exchange rate. Goldman Sachs recently revised down its three-month forecast from Rmb7.2 to Rmb7.3 against the dollar — a level it has already briefly crossed this month.
Société Générale’s forecast is far more bearish, revising its year-end forecast from Rmb7.4 to Rmb7.6. That would imply a drop of more than 10 per cent in 2023 and the largest annual fall on record since China abandoned a soft peg to the dollar in 2005.
“They can’t just disconnect the fixing from the fundamentals,” said Kiyong Seong, lead Asia macro strategist at SocGen, on the limits of the PBoC’s control over the exchange rate. “In the medium term, they will have to let the fix move to the market level.”