Cui Li: Monetary and non-monetary factors determine the RMB exchange rate

Source: China Macroeconomic Forum (CMF).

Cui Li is the Managing Director and Chief Economist of CCB International Securities

The following views are compiled from Cui Li's speech at the CMF Symposium on Macroeconomic Hot Issues (Issue 78).

When discussing the RMB exchange rate, the monetary policy misalignment between China and the United States may affect short-term market expectations and exchange rate fluctuations, but it is not the only factor that determines the exchange rate, and it is not necessarily the most important factor. It is also necessary to consider multiple factors such as China's trade competitiveness, real rate of return, resilience of the balance of payments, and overseas political and economic environment. Based on the fundamentals of the RMB exchange rate, we forecast that the RMB basket exchange rate will continue to be relatively stable in the past few years in the next few years, while the RMB exchange rate against the US dollar will continue to fluctuate slightly due to the impact of the US dollar cycle.

1. Look at the RMB exchange rate around three factors

There are several aspects to consider in forecasting the movement of the RMB exchange rate. First, China's balance of payments under the current account, especially international trade, determines the demand for renminbi under the current account in the international market; second, the basic economic relationship between China and foreign countries, which can be represented by the comparison of real interest rates, determines the demand for renminbi under the capital account in the international market. The impact of inflationary real interest rates on the exchange rate is more constant than nominal interest rates, and the third is the dollar cycle. Interest rate comparisons and the U.S. dollar cycle will be influenced by the U.S.-China monetary policy cycle, but there are other variables to consider.

1. The trade surplus supports the exchange rate of the RMB basket stronger than before the epidemic

Trade and real interest rates are the two major factors that determine the movement of the RMB basket in the medium term. Judging from these two factors, the basket exchange rate should be relatively stable in the medium term. In terms of trade, everyone is very concerned about the transfer of industrial chains and global trade protection in recent years, but China's trade surplus has increased significantly since the epidemic. There are several structural factors behind this. First, China's product structure has been upgraded, the added value has increased, and the diversification of trade has increased, not only to Europe and the United States, but also to other developing countries, hedging some protectionist pressures. The other is domestic import substitution, because some countries restrict high-tech exports to China, stimulating China's investment in high-tech and internal substitution. The proportion of imported parts and components in the export of high-tech products has obviously decreased year by year. Despite the cyclical weakening of the global manufacturing sector in 2023, the mainland's trade surplus is relatively strong, a relatively persistent phenomenon since 2019, constituting medium-term support for the basket of exchange rates, and we believe this will continue to be the case in the future.

2. The actual interest rate differential between China and the United States is similar

Although the inversion of nominal interest rates between China and the United States is a hot topic in the market, for investors with long-term allocation, the level of real interest rates after nominal interest rate adjustment for inflation represents the real return of allocating RMB assets. For a long time after 2008, and during the pandemic, China's real interest rate was much higher than that of the US dollar, driven by a large inflow of funds, and the double surplus drove the RMB exchange rate to appreciate, as fiscal austerity and very loose monetary policies in developed countries suppressed real interest rates. Since the pandemic, U.S. policy expansion, inflation has risen, and nominal prices have risen. The inflation-adjusted real interest rate has risen from zero to around 2%, while China's domestic domestic demand has weakened in recent years, and the real interest rate, as measured by the adjustment of government bond yields, has also fallen slightly, to about 2% now, still in the medium-term range of 2-3%.

In view of the international experience and lessons, we judge that China will not follow the path of significantly suppressing real interest rates in the future. Therefore, although China's real interest rate advantage is no longer significant, it is not significantly lower than that of developed countries, and in the past two years, with the tightening of overseas liquidity, the incremental allocation of foreign capital to the domestic market has declined, and some funds have flowed out. However, the proportion of foreign investment allocated to the domestic bond market is still similar to that in 2019. This suggests that the demand for long-term allocation still exists, and that the stable domestic real interest rate remains attractive.

We use the model to estimate the exchange rate of the RMB basket basically within the equilibrium range and are not overvalued, which is also confirmed by the IMF's research. This is a very critical fundamental, and cross-border capital flows depend on a combination of interest rates, exchange rates, and economic fundamentals. The exchange rate valuation is moderate, the real interest rate is in line with the international level, and the impact of currency factors on cross-border funds is still relatively balanced.

Of course, cross-border investment has also been affected by geopolitics recently, but China, as a large emerging market, still has a lot of potential to attract international investors, and the improvement of the domestic economy is conducive to continuing to attract foreign investment.

3. The balance of payments has strengthened its ability to resist pressure on the strong dollar cycle

The third factor is the dollar cycle. Because many transactions and debts in the international market are settled in US dollars, even if the exchange rate of the RMB basket is relatively stable, it will be risky if it fluctuates too much relative to the US dollar. So the market is very focused on the dollar cycle. In particular, the exchange rate's ability to withstand pressure during a strong dollar cycle. In the process of this round of dollar strengthening, the exchange rate of most countries weakened relative to the dollar. In the past, emerging market currencies tended to depreciate sharply during the strong dollar cycle, but under the strong dollar cycle that began in 2022, the average depreciation of emerging markets was not as large as that of developed countries, indicating that emerging markets' resilience has increased. The reasons for this include trade surpluses, the depth of the local currency market, and so on. The same is true for China, where depreciation pressure relative to the US dollar is relatively limited, and the basket of exchange rates has appreciated.

Compared with 2015, the outflow of funds from domestic residents during the strong dollar cycle was not very large. At that time, because there was a large mismatch in the foreign exchange position of residents, the expected change in the exchange rate put residents with pressure to buy US dollars to cover their positions, and this phenomenon improved a lot in this round, and the management of domestic foreign exchange positions and exports was more prudent, and the ability to resist pressure increased. During the Fed's interest rate hikes, it can better manage the depreciation pressure on the bilateral exchange rate and avoid overshooting.

Second, U.S. fiscal policy will also affect U.S. interest rates and U.S. dollar fluctuations

In the external environment, it is also necessary to pay attention to factors other than monetary policy, and in the future, it is necessary to pay special attention to the impact of US fiscal policy. The pressure on financial markets from the Fed is likely to decline next year, and the Fed is expected to cut interest rates by around 50 points in the second half of next year in anticipation of a steady slowdown in the US economy. Both the policy rate and the market interest rate have begun to peak, but liquidity pressures remain. Liquidity pressures come from U.S. fiscal policy. The U.S. fiscal expansion during the pandemic has boosted federal government debt, while rising interest rates have further increased deficits and debt pressures. However, the political opinions of the two parties are divided, and it is difficult to reach a consensus on fiscal austerity in the future. In addition, the introduction of industrial policy by the Biden administration means that fiscal support continues to expand, which is also the reason why it is important to support the U.S. economy in the short term. Although monetary policy has tightened, fiscal policy has been relatively expansionary.

As a result of rising fiscal deficits and debt, the supply of U.S. Treasuries will remain high in the future, squeezing market liquidity. Therefore, although the Fed's interest rate hike to the peak has led to a decline in market interest rates, the interest rate market will still be volatile due to the limited downside space for fiscal expansion. The U.S. dollar will also retreat with the high level of U.S. Treasury rates, but it is still likely to rebound periodically due to interest rate volatility and risk aversion from recession fears.

Overall, the U.S. dollar is still in a downward stage of volatility, and the exchange rate of the renminbi against the U.S. dollar will rebound in the future.

Third, the market's adaptability to the flexibility of the RMB exchange rate has increased

In the past, "7 protection" was a key issue, but since last year, when the RMB exchange rate against the US dollar exceeded 7, the market's response has been stable, indicating that the market's adaptability to exchange rate fluctuations has increased. This is a good thing for the development of the exchange rate system. As a major trading country, while still using a large number of US dollars in the balance of payments, changes in the RMB exchange rate have different impacts on different sectors. The impact of these divergent directions is particularly pronounced during a strong dollar cycle: a weaker renminbi relative to a stronger dollar is good for trade competitiveness, but too weak a renminbi can have an impact on the balance sheets of some sectors. The solution is: first, continue to increase the flexibility of the RMB exchange rate in the future development process, so that the market can gradually adapt to exchange rate changes, encourage the market to increase exchange rate hedging, hedging, and risk avoidance. The second is to increase the use of the renminbi in cross-border transactions and reduce dependence on the US dollar, that is, to promote the internationalization of the renminbi, which is very important for managing exchange rate risks.

Fourth, the RMB is expected to rise above the 7 mark

There are two factors that will be good for the renminbi against the US dollar next year: the first is trade, and the trade surplus is supported by structural factors. The recovery of the global manufacturing cycle is expected to support the cyclical trend. This year is a global manufacturing destocking cycle, and when this cycle passes, next year's trade situation will rebound, which is good news for trade across Asia. The semiconductor cycle indicator is also developing positively, so trade should be positive next year.

The second is the US dollar, which is expected to continue to weaken amid fluctuations next year, and the weakening is due to the Fed's rate hikes peaking, and historically because the dollar has peaked. The volatility stems from two factors, one is the expansion of fiscal policy, and the possibility of a rebound in interest rates, and the second is that the market will worry about the risk of recession, which will create a risk-off mood that will allow the dollar to appreciate periodically.

In the past month or so, as the Federal Reserve stopped raising interest rates, the US dollar retreated, and the RMB exchange rate against the US dollar rebounded. We expect the RMB to continue to strengthen slightly against the USD amid volatility. It will be below 7. Of course, due to many internal economic problems that need to be solved urgently, the recovery of domestic demand is not strong, and it is difficult for the RMB basket exchange rate to have room for significant appreciation.

Fifth, with the support of exchange rate fundamentals, the opening up of the capital account should be steadily promoted

There have been some outflows amid rising overseas interest rates and a stronger dollar, but China's overall balance of payments remains relatively strong, with a strong basket of exchange rates. The pace of continued opening-up should be maintained to facilitate the internationalisation of the renminbi and further increase the resilience of the balance of payments.