China’s RMB Will Keep Flat Until Year-End

The author is Capital Economics’ China economist, Qinwei Wang

China’s stock market fell in late October as money-market rates surged. A rerun of June’s cash crunch is not on the cards, but there is increasing evidence that the policy stance is shifting back towards reining in credit growth.

Meanwhile, the RMB has been allowed to resume appreciation. Equity markets across most of emerging Asia have made small gains this month, thanks to an improvement of risk appetite and the return of capital flows from overseas.

By contrast, the performance of China’s stocks has been poor. The fall in the Shanghai Composite in late October more than offset gains earlier in the month.

The trailing P/E ratio of the Shanghai Composite has stabilized over the last few weeks, after picking up somewhat over the summer. It is close to the equivalent for the Hang Seng, but remains much lower than that of the S&P 500.

Property stocks, down by 7.7% this month, have led the fall in the Shanghai composite, as it has become clear that the outlook for the sector remains difficult.

Industrial stocks have also joined in the fall recently, presumably reflecting concern about the momentum of the economic rebound given that the bulk of September’s data on activity and spending were weaker than most had expected.

Meanwhile, a tightening of monetary conditions seems to have put additional downward pressure on equity prices more recently. Interbank rates surged to four-month highs in late October. Admittedly, there is a seasonal pattern around this time of the year, linked to corporate tax payments squeezing funds.

But there are increasing signs that policymakers intend to send a message that they are once again taking efforts to rein in unsustainable fast credit growth.

Indeed, the People’s Bank of China in the second half of October halted its liquidity injection market operations for nearly two weeks, for the first time since July.

Operations were resumed this week, which should ease fears of a rerun of June’s cash crunch. But the PBoC also raised the interest rate for its operations, after having kept it stable since early August, another hint of the PBoC’s policy stance shifting.

This has had the effect of pushing onshore government bond yields higher. The rise in long-term bond yields may also reflect growing expectation of further interest rate liberalization this decade – removing the deposit rate cap will likely lead to higher market interest rates.

Offshore bond yields have fallen, but only fractionally, a sign that overseas enthusiasm for RMB-denominated assets has not yet returned. There have been barely any dim sum bond issuances recently, and none over the summer.

One major reason is that RMB appreciation expectations are still low. While the currency was allowed to appreciate this month after being kept stable in the third quarter, it has weakened somewhat this week.

We continue to think the RMB will likely end this year around RMB6.10 to 1 U.S. dollar, similar to the current level.

Policymakers have made new efforts to increase the attraction of the RMB in global markets this month. Investors based in London and Singapore will be allowed to apply for a licenses to invest RMB directly in China’s financial market, under a RMB Qualified Foreign Institutional Investor (RQFII) pilot, modeled on a similar scheme launched in Hong Kong in 2011. The overall new quota is small, just RMB130 billion ($21 billion).

Significant capital account liberalization is still unlikely in the near term, as a flexible exchange rate is generally seen as a necessary precursor. The PBoC’s balance sheet data show that it has continued to intervene aggressively to stabilize the RMB exchange rate during trading.

Finally, the Hong Kong dollar has been relatively stable at a level close to the strong side of its band over the last few weeks. Hong Kong’s currency board arrangement ensures that the monetary authorities have ample foreign exchange to maintain the currency peg in the face of shifting sentiment.

(The article has been edited for clarity)

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