The author is chief China economist at Capital Economics Mark Williams
The recent abrupt fall in the RMB is best seen as a salvo in a battle between policymakers who believe that China’s currency is close to its fair value and market participants who don’t.
Fundamentals support those who expect further appreciation over the medium term. But given the People’s Bank of China’s (PBoC) stance, there will be volatility along the way.
We cannot be certain that the weakness in the RMB over the past week or so was the result of policy intervention but we can be fairly sure. There has been no sign of a reversal in any of the usual sources of RMB demand that have underpinned steady appreciation pressure.
January’s trade surplus was one of the largest on record. Offshore, the renminbi (CNH) has been trading at a significant premium to the onshore (CNY) rate. This is a sign that market participants have been expecting further appreciation and is likely to have been accompanied by capital inflows.
Most commentators have interpreted the renminbi’s slide as an effort by the PBoC to deter speculative purchases of the RMB. That explanation is probably correct but it is important to put the intervention in context to understand the unusual (for the RMB) scale of the currency move.
The PBoC has been trying to deter speculative inflows for much of the time since the currency peg was relaxed in 2005. One approach has been to inject some volatility into the exchange rate so that the RMB hasn’t always been, at least in the short-term, a one-way bet.
But officials at the PBoC also accepted that market fundamentals pointed towards continued currency appreciation. As a result, their primary line of defence against speculative inflows was the maintenance of capital controls.
More recently though, the PBoC seems to have come to the view that the RMB is now close to its fair market value. If so, the PBoC should be able to stop continued foreign exchange accumulation. In addition, a key constraint to opening up the capital account has been lifted.
In turn, the PBoC is likely to engineer greater exchange rate volatility in the future, for two reasons. One is that officials want to shift what they see as engrained (but unjustified) expectations that the currency will appreciate.
The second is that ongoing, gradual capital account liberalisation will weaken the existing primary defence against capital inflows.
Of course, whether or not a bout of market volatility is enough to reset market expectations depends on whether the PBoC is right that the RMB is near fair value. We don’t think so.
China’s current account surplus remains large and looks likely to grow. The healthy returns on funds invested in China are still attracting more capital to the country than is going overseas.
In that case, this battle with the market is one that the PBoC will ultimately lose. We continue to expect further exchange rate appreciation this year.
Our end-year forecast of the exchange rate remains at RMB5.90 per U.S. dollar along with substantial foreign exchange accumulation. But investors should be prepared for greater volatility along the way.
(The article has been edited for clarity)