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China’s foreign exchange policy and the outlook for the renminbi

Since 2014, the People’s Bank of China (PBoC) has pursued a renminbi policy that targets a stable trade-weighted exchange rate based on the CFETS (China Foreign Exchange Trade System) basket instead of a stable cross-rate between the Chinese yuan and the US dollar (the CNY-US dollar cross rate).

China's foreign exchange policy

Since 2014, the People’s Bank of China (PBoC) has pursued a renminbi policy that targets a stable trade-weighted exchange rate based on the CFETS (China Foreign Exchange Trade System) basket instead of a stable cross-rate between the Chinese yuan and the US dollar (the CNY-US dollar cross rate).

However, it has also made tactical adjustments to this ‘stable renminbi’ policy from time to time, depending on market sentiment and movements in the US dollar. These policy adjustments have, in turn, caused confusion in financial markets about China’s intentions with regard to foreign exchange policy.

In managing onshore sentiment with the objective of minimising  capital outflow pressures, the PBoC realises that what matters most is the CNY-US dollar cross rate, not the trade-weighted exchange rate (nor the CFETS index).

When sentiment on the renminbi has been stable and the US dollar strong, the PBoC has allowed the renminbi to depreciate against the dollar so as to keep the trade-weighted exchange rate stable.

In other words, the PBoC has used the CNY-US dollar cross-rate as an adjustment factor to anchor a stable CFETS index. This approach was used between 2015 and 2016 when the dollar strengthened against all currencies in the renminbi basket, putting significant upward pressure on the trade-weighted index. To arrest that upward pressure, the PBoC allowed the renminbi to drop against the dollar (see Exhibit 1).

Exhibit 1: A steady depreciation of the Chinese yuan relative to the US dollar - the graph shows changes in the exchange rate of the Chinese yuan to the US dollar during the period from 31/12/14 through 01/06/17 (the graph shows the number of Chinese yuan for 1 US dollar)

China's foreign exchange policy

Source: CEIC, BNP Paribas Asset Management Asia, as of 01/06/17

However, when renminbi sentiment became extremely negative and volatile, causing rampant capital outflows, the PBoC shifted back to targeting a stable CNY-US dollar cross-rate and allowed the CFETS index to adjust. In other words, a stable CNY-US dollar cross-rate was contingent upon poor sentiment toward the renminbi.

This tactic  was employed intermittently in China's foreign exchange policy until early this year when the PBoC allowed the trade-weighted exchange rate to fall, even though the sentiment on the renminbi had improved significantly since the start of the year. The PBoC should have moved to keep the trade-weighted exchange rate stable, but it did not.

What is going on has a lot to do with the change in the direction of the US dollar and economic conditions in China.

Contrary to market expectations early this year, the dollar has actually weakened, not strengthened. At the time of writing, the US dollar index has fallen by more than 3% from January, while the CNY-USD cross-rate has been stable since its 1% jump in early 2017. So the CFETS index has followed the dollar down. The PBoC has again adjusted its foreign exchange policy - taking advantage of the weaker dollar - to depreciate the trade-weighted exchange rate while keeping the CNY-USD cross-rate stable, even though sentiment toward the renminbi has improved (see Exhibit 2).

Exhibit 2: The PBoC has taken advantage of the weaker US dollar to depreciate the trade-weighted exchange rate (shown by the CFETS index) while keeping the CNY-USD cross rate relatively stable

China's foreign exchange policy

Source: CEIC, BNP Paribas Asset Management Asia, as of 01/06/17

It is notable that this change in tactics has come at a time of fading capital outflows due largely to a decline in the repayment of foreign liabilities by Chinese firms and effective capital controls. As a result, sentiment towards the renminbi has improved, as shown by the rise in the ratio of FX-settlement-to-FX-receipts by Chinese bank clients (see Exhibit 3). This reflects a rise in the percentage of foreign exchange actually sold in the market out of foreign exchange receipts, and thus indicates that domestic foreign exchange recipients intended to sell more foreign exchange and hold more renminbi.

Exhibit 3: The FX-settlement-to-FX-receipts ratio for clients of Chinese banks shows a greater inclination to hold renminbi rather than foreign currencies on the part of Chinese clients

China's foreign exchange policy

Source: CEIC, BNP Paribas Asset Management Asia, as of 01/06/17

However, despite these positive developments the PBoC still wants to depreciate the trade-weighted exchange rate in order to generate some growth momentum for the domestic economy.

It is thus arguably pursuing a ‘dirty float’ foreign exchange policy for the CFETS index.

With economic recovery taking hold in China, we believe it is likely that the PCoC will shift back towards a stable trade-weighted foreign exchange policy soon.

Sentiment on the renminbi has turned positive due to a stabilisation of the Chinese economy, declining capital outflows and receding worries about China’s debt crisis (due to the narrowing gap between China’s credit and nominal GDP growth).

Should the US dollar weaken further, a return by the PBoC to targeting a stable CFETS index would point to a strengthening renminbi against the US dollar in the coming months.

In our view, there is a fair chance that the renminbi could end this year by appreciating to a level below than 6.9 renminbi per US dollar. For investors, one implication of this is that it could make Chinese (notably fixed income) assets more attractive, assuming that regulatory tightening ends before the 19th Communist Party Congress later this year.


Written on 24 May 2017

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

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