Asia | China | Emerging Markets | FX | Monetary Policy & Inflation
As the market waited for President Trump to announce dramatic punitive measures against China on 28 May, the RMB fell to its weakest point this year. However, the Trump administration balked at tearing up the Phase 1 trade deal. The RMB quickly stabilized and, I suspect, is poised to appreciate vs the USD.
I am not ruling out a re-escalation of trade tensions at some point in this election cycle. But in my opinion, there is no fundamental reason for USDCNY to rise significantly, except in the scenario where either side scraps the Phase 1 trade deal. As a core view, I am now cautiously bullish on RMB.
My reasoning is as follows:
The main reason for RMB weakness in the last two years was that the PBoC used FX devaluation to offset the effect of higher tariffs. This is very different from the 2015-16 period, where enormous and destabilizing capital outflows from China drove persistent weakness. In fact, net settlement flows in the last two years have been entirely within PBoC & SAFE’s control. FX reserves have remained stable. RMB devaluation in the last two years was a deliberate policy decision, rather than an intractable Balance of Payments problem.
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As the market waited for President Trump to announce dramatic punitive measures against China on 28 May, the RMB fell to its weakest point this year. However, the Trump administration balked at tearing up the Phase 1 trade deal. The RMB quickly stabilized and, I suspect, is poised to appreciate vs the USD.
I am not ruling out a re-escalation of trade tensions at some point in this election cycle. But in my opinion, there is no fundamental reason for USDCNY to rise significantly, except in the scenario where either side scraps the Phase 1 trade deal. As a core view, I am now cautiously bullish on RMB.
My reasoning is as follows:
- The main reason for RMB weakness in the last two years was that the PBoC used FX devaluation to offset the effect of higher tariffs. This is very different from the 2015-16 period, where enormous and destabilizing capital outflows from China drove persistent weakness. In fact, net settlement flows in the last two years have been entirely within PBoC & SAFE’s control. FX reserves have remained stable. RMB devaluation in the last two years was a deliberate policy decision, rather than an intractable Balance of Payments problem.
- Monetary policy divergence. While wrapping up the NPC meeting on 28 May, Chinese Premier Li Keqiang summarized China’s post Covid-19 policy orientation as follows: ‘we are now providing water so that the fish can survive. Fish will die without enough water, but there will be bubbles if we provide too much water.’ How would you compare that to the Fed’s open-ended QE? Rate differentials are a fallible metric, and indeed there’s not much day-to-day correlation with USDCNY. However, they have been a good guide for medium-term trends in the currency (Chart 1).
- I concede that much depends on the US election result. If the incumbent wins, the market will have to price in risk of higher tariffs (and thus a weaker RMB). But if the results go the other way, I doubt President Biden would stick with President Trump’s signature policy of unilateral tariffs. Other forms of containment and economic disengagement will likely continue, but I don’t think a weaker RMB is a useful offset against these.
- Current market sentiment and positioning is moderately bearish on RMB. This can be inferred by the amount of option premia the street is spending (call/put ratio, Chart 3) and the offshore/onshore fwd risk premia. To be sure, these indicators don’t flag an extreme overhang. But there is a disconnect here compared with the big sentiment swing which the dollar has already suffered.
Chart 1: USDCNY vs 2Y Bonds Yield Differential
Source: Bloomberg, Morgan Stanley Asia Macro Trading
Chart 2: Net FX Settlement Data Shows Capital Outflows Have Been Under Control
Source: Bloomberg, Morgan Stanley Asia Macro Trading
Chart 3: USDCNY vs Call/Put Ratio
Source: DTCC, Morgan Stanley Asia Macro Trading
Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank
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