China's trilemma and the renminbi's fall
Endowus Insights

Leap into prosperity this CNY 💰     Get an $88 head start to growing your wealth.

Leap into prosperity this CNY 💰Get a $88 head start to growing your wealth.

China's trilemma and the renminbi's fall

Updated
24
Nov 2022
published
13
Sep 2022
chinese yuan - currencies - forex

Our thoughts:

While targeted fiscal action remains in China's toolkit, volatility could persist in Chinese markets, given that the renminbi acts as the main escape valve for the country's economic pressures.

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

Source: Bloomberg, as of 29 April 2022. A lower number denotes appreciation against USD.

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

Source: Bloomberg, 29 April 2022

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

Source: Bloomberg, 29 April 2022. A higher number denotes depreciation against USD.

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.

Endowus has three funds from Janus Henderson (as of 13 Sep 2022), including the Asia-Pacific Property Income Fund, and the Global Life Sciences Fund.

Get started building your own portfolio with these funds on the Endowus Fund Smart platform.

<divider><divider>

Janus Henderson Investors disclaimer

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

Anything non-factual in nature is an opinion of the author(s), and opinions are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use.

<divider><divider>

Endowus disclaimer

Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund. 

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this material are subject to market influences and contingent upon matters outside the control of Endow.us Pte. Ltd (“Endowus”) and therefore may not be realised in the future. Further, any opinion or estimate is made on a general basis and subject to change without notice. In presenting the information above, none of Endowus Pte. Ltd., its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision. 

You should carefully consider (i) whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

More on this Tag
chinese yuan - currencies - forex

Table of Contents