While growth and policy concerns in the markets have undermined the renminbi recently, its long-term appreciation trend remains intact, argues Chi Lo, senior economist Greater China.
Freer rein for market forces
The recent volatility of the renminbi shows that the People’s Bank of China (PBoC) is exiting its policy monopoly as part of wider economic reforms. The renminbi is a heavily managed currency and its recent depreciation would appear to have been engineered by China’s central bank as part of Beijing’s grand strategy for internationalising its currency, which includes giving it the status of an official reserve currency. Opening up the market to foreign participants and giving market forces more leeway implies doing away with the perception that the renminbi can only rise, widening the trading band and permitting more volatility.
But rebalancing the economy – shifting away from investment as the main growth engine to consumption and services – is a delicate affair. To rein in debt excesses in the property and shadow banking markets, the PBoC has sharply curtailed the flow of cheap credit, retraining its sights on the pursuit of quality growth, including the promotion of deleveraging, addressing systemic risks and encouraging structural reforms. This tightening bias, reflected in the recent drop in aggregate liquidity and the rise in the seven-day repo rate, can be expected to last several years.
At the same time, though, we expect the central bank to ensure that aggregate liquidity will be sufficient to sustain Beijing’s GDP growth target, set at a still brisk 7%-8% for 2014.
Renminbi rout to stabilise growth
The PBoC’s recent curbs on the flow of cheap credit caused domestic growth to slow more severely than expected. To counter the threat of an economic hard landing, weakening the renminbi can be seen as a useful policy fine-tuning tool. A weaker currency can fire exports and preserve the pace of GDP growth, while lifting import prices and encouraging consumption as (imported) inflation picks up.
Support for the economy also came in the shape of a modest government stimulus package focused on investment in railways and social housing. Illustrating the effectiveness of the measures to put a floor under growth, the latest official PMI data indicated that the crucial manufacturing sector was stabilising.
Arguably, the threat of higher inflation from a weaker currency should be limited. Core inflation has not exceeded 2% in the past decade, while producer price inflation has been non-existent for more than a year. At the same time, urban household income has stabilised, rural and migrant workers’ income growth is picking up mildly and demand for labour exceeds supply. Accordingly, a negative policy shock in the form of central bank action to curb inflation looks unlikely at this point.
Of course, a devaluation policy might provoke tensions with China’s trading partners. But if devaluation is only temporary and helps balance growth with structural reforms, Beijing should be given the benefit of the doubt.
One step backwards for three steps forwards
Looked at in perspective, the renminbi’s drop occurred over a matter of weeks only and was hardly unprecedented. The latest weakness was merely a dent in an eight-year trend of gradual appreciation against the US dollar and other major currencies. It surprised investors who were used to the slow and steady rise that made the renminbi one of the world’s strongest-performing currencies in 2013, rising by 3% against the US dollar, in line with similar size gains since 2005.
We believe the currency’s long-term appreciation trend is unbroken. It remains undervalued relative to the country’s strong economic fundamentals, which include a healthy balance of payments, while the advancing internationalisation of the renminbi should continue to fan investor interest. We are still looking for further gains on the US dollar, though the pace of the advance might well be milder than that of recent years and further bouts of volatility might still cause the currency to swerve from this track on occasion.
Stay cool and keep eyeing the opportunity
From an investor viewpoint, the renminbi’s appreciation potential reinforces the 100bp-200bp yield pick-up that offshore RMB government and non-government bonds already provide relative to bonds in large international markets with a similar credit rating. The short duration of the offshore RMB market is a further favourable feature that should support international investor (and local depositor) demand.
Undeniably, there are risks. The squeeze on shadow banking and local government debt issuance could sap local government and non-state spending. Rising interest rates could also undermine overall growth, as could overly harsh measures to slow property investment, especially in non-prime cities. Further bond defaults could cloud the perception investors have of the Chinese fixed income market, though they should remember that such hiccups are part of the market’s progress towards maturity and the current economic reforms are long-term positives that should be uppermost in investors’ minds.
Overall, we believe there are convincing reasons to have faith in the feasibility of the reforms, the government’s rebalancing efforts and its growth targets. Thus, rather than being a concern, any short-term weakening of the renminbi can be seen as an opportunity for investors with steady nerves.