The RMB is roughly 10% overvalued. A depreciation makes economic sense and the Chinese currency is likely to decline 7% against the U.S. dollar to around 7 CNY/USD in the next 12 months, says AXA Investment Managers Asia in a new research report.
RMB: A New Channel Of Risk Transmission
China’s exchange rate reform last August, which linked the RMB’s exchange rate to a basket of currencies and led to the largest one-day fall in the onshore exchange rate, was an integral part of China’s financial system reform.
Following the de-peg from the U.S. dollar, China also introduced an RMB trade-weighted index, which consists of 13 currencies.
This transition of official reference exchange rate from the CNY/USD to the trade-weighted index marks a significant shift in China’s foreign exchange regime.
The move, however, was interpreted by the markets as a way for China to boost exports. In fact, the yuan has only depreciated 6% against the U.S. dollar during the past 12 months, and 3% since last August.
The other side of the coin, which is often overlooked, was that the RMB actually strengthened against other currencies, especially emerging Asian countries and those who are commodity exporters.
The overall trade-weighted RMB exchange rate index stayed broadly flat. It means that the CNY/USD move was driven more by the strengthening of the U.S. dollar, rather than the Yuan’s weakness.
A Thought Experiment To See The RMB’s Future Trend
If China completely opens up its capital accounts and exchange rate, a rational guess would be to see an increase in net capital outflows.
Chinese companies and households would most likely take this opportunity to diversify their portfolios and shift part of their assets abroad.
This movement might be reinforced by the fear of being trapped again in case of a return to capital controls.
But, gross capital inflows may also increase, as foreign investors would be reassured by the possibility of freely repatriating their assets.
Putting all the considerations together, we would expect the RMB to sharply depreciate in the short run.
Looking at the medium term, it would still make sense for the RMB to depreciate further against the U.S. dollar, considering that the U.S. Federal Reserve is tightening while the Chinese central bank is adopting accommodative monetary policies.
The RMB would behave very much like other emerging market currencies. On top of that, the Chinese currency also faces an unfavorable economic slowdown.
In the long run, China would maintain the same net external investment position as today, with the country remaining a net creditor to the world.