China's trilemma and the renminbi's fall

No longer a place to hide

China’s onshore renminbi (CNH) has been an oasis of calm over the last year and was, up until recently, one of the few Asian currencies that had outperformed the US dollar (USD).

Its strength has been fortified by a strong twin surplus in China’s current and capital account, with a trade surplus driven by strong exports. The balance of payments — the difference between money flowing into and out of an economy — has shifted, with disruption to exports from lockdowns arising from China’s zero-tolerance approach to a resurgence in Covid-19 cases. 

Coupled with policy uncertainty and diminishing growth prospects, these headwinds are dampening investor appetite for Chinese assets, depressing the currency.

Asian currencies' performance vs the US dollar

Relative attractiveness wanes

China has diverged from the rest of the globe in its tentative lean toward easing, while most economies are synchronised toward tightening. 

As China’s policy has diverged from the US, the yield differential between US and China 10-year government bonds has broken into negative territory for the first time since 2010. 

More broadly, as the average yield in other global government markets — such as the EU and UK — continues to trend higher, the incentive to invest in the Chinese market dwindles, particularly against a backdrop of policy uncertainty in the country.

China-US 10-year government bond yield differential dips into negative territory

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The US Federal Reserve’s increasing hawkishness on a front-loaded tightening cycle has compounded the renminbi’s weakness and contributed to a reversal in the trend of money flowing into China. 

Capital inflows into the currency were encouraged by greater representation of China in fixed income and equities indices, but the tide has turned into US$44 billion of foreign capital outflows this year. 

China's trilemma

China faces what is characterised in economics as a “policy trilemma”, where a country cannot simultaneously achieve exchange rate stability, independent monetary policy, and free capital movement, but only two of these. 

China faces the requirement to ease financial conditions to reach its economic growth target. One of the ways it aims to do this is by reducing the foreign exchange (FX) reserve requirement ratio — the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest, for foreign exchange activities. This aims to increase liquidity in the domestic (onshore) US dollar market, which slows down renminbi depreciation.

China’s central bank has just cut the FX reserve requirement ratio to 8% (as of May 2022, at the time of writing). This will be further reduced to 6% from 15 Sept 2022, to “improve financial institutions’ ability to use foreign exchange funds”, the People’s Bank of China (PBOC) said in early September this year.

China will want to manage its renminbi dollar exchange rate to avoid swinging too much in either direction, as it wants its exports to be attractive while not destroying demand for Chinese assets. Capital market reform toward openness has left it susceptible to outflows, so currency volatility is the unfortunate, but inescapable, side effect.

As renminbi weakness has been relatively contained, it appears that markets currently perceive only a temporary halt to the domestic reinvestment of proceeds and repatriation of income. 

If we start to see a capital exodus akin to the 2014-2016 period when the PBOC spent a trillion US dollars of its foreign reserves to stabilise markets, it would place further pressure on the currency as the main escape valve to stabilise the situation. That period marked a time of significant volatility in Chinese assets.

In light of the risk of further capital flight, we expect such currency moves to be only the beginning of a longer-term trend of depreciation. 

A continuation of this weakness, in our view, should be expected. A further 8-10% depreciation might be required for the renminbi to approach similar trends seen in other Asian currencies (as highlighted in the first chart, on Asian currencies vs USD). 

The first real test for the currency is if the exchange rate versus the US dollar will be contained below 7 — psychologically, the level deemed acceptable by market participants — or if it goes beyond this and the central bank directly intervenes in currency markets.

US dollar vs the renminbi (CNH) remains below 7

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Uncertainty ahead

On the positive side, a weaker currency can help Chinese growth, as exports form a significant part of China’s economy — necessary if the country is to meet its 5.5% GDP growth target.

As the government tries to tackle the challenges of stamping out Covid-19 completely, progressing on its “shared prosperity” agenda, and maintaining growth around its expected target, volatility will likely remain high across Chinese financial assets. 

The “shared prosperity” agenda has increased investor uncertainty around policy towards markets, as shown by the regulatory tightening over key strategic industries.

We believe the renminbi will act as the main escape valve for the country’s economic pressures and continue to depreciate. Chinese authorities until now have not shown particular attention to a specific level they will tolerate, but they have shown some signs of concern due to the speed of the move. 

To circumvent the trilemma, outside of monetary policy, targeted fiscal action offers a potential solution to reinvigorate growth. 

Financial assets are also dependent upon exceptional policies from the government that can be enacted in very short order, such as coal tax cuts and extra infrastructure spending.

This article was originally published by Janus Henderson Investors in May 2022.

Janus Henderson Investors is a global asset manager offering a full suite of actively managed investment products across asset classes. Established through the merger of Janus Capital and Henderson in 2017, Janus Henderson’s history as independent investment managers stretches back to 1934.

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