China: Fed Hikes and the Sliding RMB

Published on May 24, 2016

Key Takeaways:

•    Chinese officials have lingering concerns over the potential impact of a Fed rate hike in June on their markets and the RMB, and will suggest to their US counterparts at a meeting early next month that a hike in July could be absorbed more easily.

•    The PBoC expects the RMB to continue to drift down as the dollar strengthens. Beijing will seek a RMB/$ central parity rate at around 6.5000-6.6000 the next two months, up from the 6.4500-6.5500 levels of March-May.

•    A sharp currency depreciation pressure is unlikely as Q2 GDP is expected to stabilize at 6.7-6.8%, and even to strengthen in the second half. But if 2H16 growth slips closer to 6.6%, the RMB could end the year closer to 6.7000.

People’s Bank of China Governor Zhou Xiaochuan, Minister of Finance Lou Jiwei and other senior Chinese financial officials will be meeting with their US counterparts in Beijing in early June for the eighth round of the China-U.S. Strategic and Economic Dialogue (S&ED).

At those meetings, Chinese officials hope to engage Fed Chair Janet Yellen and Treasury Secretary Jacob Lew in a frank discussion about US monetary and fiscal policy, and to get a clear sense for whether the Fed will raise interest rates at their upcoming meeting in June, or wait until the next meeting in July.

*** The Chinese Renminbi is inevitably coming under pressure as the possibility of a rate hike by the Fed rises. And while supportive of a Fed rate move this summer, Chinese officials appear to harbor some lingering concerns over the potential impact of a June hike on their economy and markets. From what we understand, they will note that a hike in July, assuming the US economy continues to improve and Britain does not leave the European Union, could be absorbed more easily by China than a hike in June. ***

*** Whether a Fed hike comes in June or July, the PBoC expects the RMB to continue drifting lower as the dollar strengthens, and will seek to manage the RMB central parity rate against the USD at around 6.5000-6.6000 through June and July, from the 6.4500-6.5500 levels of March-May (see SGH 5/17/16, “China: A Tap, not a Tightening”). They expect the RMB against the USD to settle around 6.6000 by year-end, even if the Fed were to raise interest rates twice this year. ***

*** The PBoC also reported a second month of rising FX reserves in April, as capital outflows eased. The central bank, however, expects the country’s FX reserves to shrink in May with an anticipated US dollar appreciation, and do not rule out the RMB sliding against the USD to 6.7000 (“at most”) by the end of 2016 if China’s economic growth were to slow against expectations to 6.6% in the second half of the year. ***

But for now, the Chinese policymakers are confident economic growth has stabilized: they believe the country’s GDP will come in around 6.7-6.8% in Q2 and perhaps more importantly, they now expect GDP in the second half of the year to come in higher than in the first half. Officials therefore expect the RMB against the USD to settle around 6.6000 by the end of 2016 even if the Fed were, as now expected, to raise interest rates twice this year.

China’s FX Reserves and Flows

The PBoC reported that China’s foreign exchange reserves rose by $7.089 billion in April to $3.219 trillion, from $3.212 trillion in March — marking a second monthly rise this year and suggesting easing capital outflows amid increasing signs of economic growth and RMB stability.

As to the make-up of the FX reserves, behind the net increase of $7.089 billion, USD assets dropped by $3.36 billion, EUR assets rose by $4.72 billion, assets from major emerging market economies, including the BRICS, rose by $3.57 billion, JPY assets climbed $1.87 billion, and GBP assets rose by $234 million last month.

The report notes that the March-April figures show the overall pressure of cross-border capital outflows eased significantly compared with January-February of this year.

And according to the report, the PBoC did not sell any dollars in the spot market except on April 23 and April 27, when the central bank sold $820 million in the spot market.

The PBoC nevertheless predicts that Chinese individuals will buy about $4-$5 billion dollars in May, as the RMB has weakened slightly against USD over the past three weeks of this month.

But even for the month of May, despite the RMB experiencing a third week of declines last week, the PBoC has not seen heavy capital outflows from the country.

The RMB, PBoC officials note, in the spot market remains at “normal levels” – the gap between the onshore and offshore market was back down to within 200 pips on May 19-20 after touching a three-month high of 386 on May 18.

And the PBoC has started to allow six offshore banks to trade spot, swaps, and options in the onshore interbank currency market from May 20. They believe this added liquidity will help narrow the gap between onshore and offshore prices.

The central bank expects the currency nevertheless to slide modestly as the Fed hikes interest rates. But they expect that pace to be tempered by signs of stability in the domestic economy.

They will express confidence that the country’s FX reserves will remain above $3 trillion by the end of 2016. Indeed, they feel if FX reserves were to drop below the psychologically significant $3 trillion level, that in and of itself could fuel a self-fulfilling cycle and accelerate RMB depreciation

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