Opinion Leader 丨 Guan Tao
It is often said that exchange rate rigidity and financial openness are dangerous policy combinations. In fact, even if the financial opening policy is not adjusted significantly, in the context of increasingly open trade, it may bring great challenges to the management of capital flows.
Since June last year, the renminbi has appreciated sharply against the US dollar, with the largest cumulative increase of more than 12%. Especially at the end of May and the beginning of June this year, the RMB exchange rate showed a sharp rise, hitting a new high in the past three years. The appreciation of the renminbi and the surplus of settlement and sale of foreign exchange have become important characteristics of the current operation of the domestic foreign exchange market. However, judging from the operation of the foreign exchange market in August this year, although it cannot be said that this wave of RMB appreciation has ended, some new changes still need to be paid attention to.
In August, the domestic RMB exchange rate was stable and weak
The onshore RMB time-point exchange rate and the average monthly exchange rate both weakened. At the end of the month, the mid-price and the 4:30 p.m. closing price (the same below) fell by 0.12% and 0.13% respectively from the end of the previous month. During the month, the average monthly mid-price and closing price fell by 0.05% and 0.04% respectively month-on-month (see Figure 1).
Of course, it cannot be said that this wave of RMB appreciation is over. May 2018 was a significant inflection point in the rebound of the RMB exchange rate from the beginning of 2017 to March 2018, and since then, the RMB time-point exchange rate and the average monthly exchange rate have fallen by more than 1% month-on-month for three or four consecutive months. In August this year, the exchange rate of both the RMB at the time and the average monthly exchange rate fell relatively smallly. Moreover, in September (as of September 24, the same below), the average monthly exchange rate mid-price and closing price appreciated by 0.3% each compared with August, which still belongs to the two-way fluctuation of ups and downs (see Figure 1).
In addition, after a one-time increase in the reserve requirement ratio of foreign exchange deposits of financial institutions by 2 percentage points in June, from June to September, the average monthly 1-year RMB/USD forward swap was 1555, 1591, 1597 and 1726 basis points, respectively. This indicates that the real impact of the measures on domestic foreign exchange liquidity is limited, and the decline in the RMB exchange rate since the beginning of June is mainly due to the strengthening of the US dollar index in the international market. In September, the average monthly ICE dollar index was 92.76, up 2.7% from May (see Figure 4).
The weakness of the RMB exchange rate in the month was accompanied by a slight shortage of domestic foreign exchange
In 2015, the "8.11" exchange rate reform established the current RMB exchange rate formation mechanism determined by the domestic foreign exchange supply and demand relationship and changes in the international financial market. After the counter-cyclical factor was diluted from the mid-price quotation mechanism at the end of October last year, the transparency of the RMB exchange rate formation mechanism was further improved.
From the perspective of the average monthly exchange rate, from June last year to February this year, it continued to rise unilaterally, and since March, there have been two-way fluctuations of ups and downs. Among them, the closing prices of the exchange rate in March, April, June, July and August all fell month-on-month, but the first four months mainly reflected changes in the international financial market. In March this year, the average monthly RMB exchange rate closing price fell by 0.76% month-on-month, and the average monthly ICE DOLLAR index rose by 1.6% month-on-month, but in the same period, domestic foreign exchange was still oversupplied, and the total surplus of foreign exchange settlement and sales by banks was US$15.5 billion; in July, the average monthly RMB exchange rate closing price and the US dollar index fell by 0.76% and 1.6% respectively, and the total surplus of foreign exchange settlement and sales of banks was US$8.1 billion (see Figures 4 and 5).
In August, the RMB exchange rate trend was weaker and the "gold content" was higher, reflecting the comprehensive impact of domestic and foreign market factors. In the month, the average monthly ICE dollar index rose by 0.3% month-on-month; banks had a total deficit of US$1.6 billion in forward (including options) settlements, another deficit after a year; and the central bank's foreign exchange account also ended a four-year streak, down 2 billion yuan month-on-month (see Figures 4 and 5).
The reversal of domestic foreign exchange supply and demand is mainly due to the decline in the net settlement of unmatured forwards. During the month, banks had a spot settlement surplus of US$13.6 billion, but this part of the surplus was offset by a US$15 billion reduction in net unmatured forward foreign exchange balances and a US$200 million reduction in unexpired foreign exchange options Delta net foreign exchange exposures during the same period.
The decline in net unexpired forward balances was due, on the one hand, to the large number of expired settlements that had been expected to appreciate the exchange rate in the previous period. In the month, forward settlement performance was about US$37.4 billion, accounting for 18.6% of forward settlement performance, up 0.9 percentage points from the previous month; forward purchase performance was about US$25.3 billion, and forward purchase performance accounted for 13.8%, down 2.6 percentage points from the previous month; forward settlement and sale of foreign exchange performance surplus was US$12.1 billion, an increase of US$7.4 billion month-on-month (see Chart 6).
On the other hand, it is because companies have increased the hedging of the risk of exchange rate depreciation. In that month, the forward settlement and purchase of foreign exchange signed amounted to US$31.8 billion and US$34.7 billion respectively, and the deficit of forward net foreign exchange settlement contracts was US$2.9 billion, the first time in three years. The forward settlement (sale) foreign exchange hedging ratio, measured by the proportion of forward settlement (sale) foreign exchange contracts to the amount of exports (imports), shows that in August, the hedging ratio of forward settlement and sale of foreign exchange was 12.5%, down 1.7 percentage points from the previous month, which was the second consecutive month of decline, which reflected that the convergence of exchange rate volatility inhibited the market players' exchange rate hedging motivation. Among them, the forward foreign exchange settlement hedging ratio was 10.8%, down 2.4 percentage points month-on-month, and the forward purchase hedging ratio was 14.7%, down 0.9 percentage points month-on-month (see Figure 7). It can be seen that in the case of market depreciation expectations, the weakening of the motivation for forward foreign exchange purchases is less than that of forward foreign exchange settlement.
Currency market volatility highlights the importance of exchange rate flexibility
The large trade surplus reflects the strength of China's foreign economic sector and provides important support for the stability of the RMB exchange rate. Since the second quarter of last year, due to the good prevention and control of the epidemic, China has taken the lead in resuming work and production in the whole industrial chain supply chain, with rapid export growth and an expanding trade surplus. This year, China continues to enjoy dividends in this regard, with exports increasing by 34% year-on-year (in US dollars) in the first 8 months, and the trade surplus of US$362.5 billion, an increase of 29% year-on-year.
However, as the exchange rate is formed more and more market-oriented, the RMB exchange rate has become more and more characteristic of a mature currency. That is to say, the exchange rate trend of the RMB market is becoming more and more asset price attributes, showing random wandering, resulting in a trade surplus and exchange rate depreciation is not a simple linear relationship.
At the end of 2006, the Central Economic Work Conference proposed that promoting the balance of payments should be regarded as an important task for maintaining macroeconomic stability, that is, not to pursue a trade surplus, and the more foreign exchange reserves, the better. By the end of June 2014, China's foreign exchange reserves reached nearly 4 trillion US dollars, an increase of 2.93 trillion US dollars over the end of 2006. In the same period, the surplus of trade in goods of customs caliber accumulated to US$1.69 trillion, equivalent to 58% of the increase in foreign exchange reserves.
In 2015, the "8.11" exchange rate reform unexpectedly depreciated, triggering the centralized adjustment of the market to "hide foreign exchange from the people" and "debt repayment". As a result, although the annual trade surplus in 2015 and 2016 was more than $500 billion, far exceeding the average annual surplus of more than $200 billion from 2007 to 2013, it did not meet the scale of capital concentration outflows, resulting in a continuous decline in foreign exchange reserves. By the end of 2016, the RMB exchange rate had fallen to around 7, and foreign exchange reserves had fallen to around 3 trillion yuan, and the market was fiercely defending the exchange rate or guaranteeing reserves.
In the current round of RMB appreciation, the correlation between the trade surplus and the bank settlement and sales surplus is also relatively low. From January last year to August this year, the correlation between the balance between customs imports and exports and the balance between banks, that is, forward (including options) settlement and sale of foreign exchange, was a very weak positive correlation of 0.149, of which from February to August this year, it turned into a very weak negative correlation of 0.265. In August this year, the customs import and export surplus was US$58.3 billion, an increase of US$1.9 billion month-on-month, but the bank's foreign exchange deficit, that is, forward (including options), widened by US$9.7 billion month-on-month (see Figure 5).
It is often said that exchange rate rigidity and financial openness are a combination of threatening policies. In fact, even if the financial opening policy is not adjusted significantly, in the context of increasingly open trade, it may bring great challenges to the management of capital flows. Traditional challenges are the early or late receipt and payment of imports and exports, as well as the transfer pricing behavior within multinational companies, which has the potential to break through the barriers of capital controls. The new challenge is that in guiding enterprises to uphold the awareness of risk neutrality and increase the hedging of exchange rate risk, it may also cause a large inflow of funds.
As mentioned earlier, in August this year, the domestic foreign exchange supply and demand relationship reversed slightly, which was caused by the market increasing the hedging of exchange rate depreciation risk. During the current period, the surplus of banks' spot settlement and sales increased by US$3.9 billion month-on-month, of which the surplus of foreign exchange settlement and sales on behalf of customers was US$23 billion, an increase of US$7.6 billion from the previous quarter, contributing nearly twice the increase in the margin of banks' spot settlement and sales of foreign exchange. However, the decline in exposure to unmatured forward net foreign exchange and FX options Delta net settlement during the same period led to an early net purchase of foreign exchange by using $13.6 billion in the spot market of banks, offsetting the increase in the spot settlement surplus.
According to the theory of exchange rate overshoot, asset price adjustment is usually faster than that of the real economy, resulting in the market exchange rate being prone to excessive rise and depreciation of the equilibrium exchange rate determined by relative economic fundamentals. Extremes such as the high-intensity cross-border capital flow impact that occurred in the early days of the "8.11" exchange rate reform, it took ten years to accumulate a trade surplus of 2 trillion yuan, but the capital outflow in two years was trillions of yuan. This kind of time mismatch has caused a serious imbalance between foreign exchange supply and demand in the short term, and only then has there been an abnormal situation in which a large trade surplus is accompanied by strong depreciation expectations. The recent currency market volatility is not the same as six years ago, but it has once again sounded a wake-up call for the market not linear but non-linear.
When there is an imbalance between supply and demand of foreign exchange, either the price is cleared (exchange rate fluctuation) or the quantitative clearance (foreign exchange reserve intervention or capital exchange control) policy choice (that is, the "impossible triangle" of foreign exchange policy). If we choose to increase the degree of marketization of the exchange rate and increase the flexibility of the exchange rate, it will help to reduce the dependence on quantitative instruments, especially administrative control tools. Since the RMB exchange rate shifted from unilateral decline to two-way fluctuations in 2018, especially since the RMB exchange rate broke through 7 in August 2019, we have initially enjoyed the benefits of this aspect. In the next step, we must continue to deepen the reform of exchange rate marketization to better meet the needs of open economic development and continue to promote trade and investment liberalization and facilitation.
This article was originally published by CBN
(About the author: Global Chief Economist of BOC Securities)