- The renminbi has strengthened 8% against the dollar over the last year, driven by a resurgent trade surplus and strong flows of foreign investment into China's onshore bond market.
- Capital outflow restrictions may be loosened this year, as regulators seek to balance inbound and outbound flows and reduce appreciation pressure.
- Likely areas for regulatory loosening include portfolio investment by retail investors, outbound foreign direct investment, and cross-border cash management by multinationals.
The renminbi is facing strong appreciation pressure. Strong global demand for Chinese exports during the pandemic pushed China's trade surplus to a record high last year. Meanwhile, China's strong domestic economic recovery has enabled policymakers to begin winding down pandemic-related stimulus, even as the Fed keeps interest rates low and the US enacts big new fiscal stimulus. This policy divergence has pushed up the renminbi's yield premium over US dollar assets, making Chinese bonds attractive to foreign investors.
These global economic and financial trends favoring renminbi strength appear to be causing a shift in the focus of the PBoC's exchange rate policy. Since the financial turmoil of 2015-16, when capital flight and sharp renminbi depreciation caused Chinese regulators to tighten controls on foreign exchange outflows, the PBoC's main priority has been to contain renminbi depreciation expectations and prevent further drain of China's foreign exchange reserves, which fell by roughly USD 1tn between 2014 and 2016. This preoccupation with the risk of disorderly depreciation was the basis for our argument in 2019, against consensus, that the USD/CNY exchange rate crossing 7 was not an act of intentional devaluation.
Over the last two years, the PBoC has apparently engaged in stealth intervention on a modest scale to restrain renminbi appreciation. Now, with economic fundamentals likely to continue supporting renminbi strength for at least the next year, the PBoC may take further steps to relieve appreciation pressure. Stealth intervention may continue, but there are limits to how much the PBoC can resist appreciation pressure using such methods. Similarly, the PBoC's traditional method of restraining renminbi appreciation – direct PBoC purchases of US Treasuries for official foreign exchange reserves – would risk re-igniting US complaints about currency manipulation.
Resisting appreciation without intervention
Loosening restrictions on foreign exchange outflows offers an answer to the problem of how to relieve renminbi appreciation pressure without resorting to large-scale intervention. On 12 March, the PBoC announced a pilot program enabling selected multinational companies in Beijing and Shenzhen to convert renminbi to dollars without specific authorization from the State Administration of Foreign Exchange (SAFE). Since September, SAFE has also expanded the quota for outbound portfolio investment by institutions under the Qualified Domestic Institutional Investor Program by around USD 12bn. Though tiny in the context of overall cross-border flows, this amount was the largest quarterly increase in the program since 2007, and further quota expansions may follow this year.
These incremental moves signal the PBoC's broader orientation. In February, PBoC Governor Yi Gang said that the central bank was considering a policy change to allow individuals to use their annual forex conversion quotas to invest in foreign securities. Chinese individuals are currently allowed to buy USD 50,000 per year in foreign currency, but these funds can only be used for current account transactions such as foreign travel, shopping, and tuition. Expanding the allowable uses would encourage more individual to make use of their annual quotas, encouraging greater outflows.
A likely destination for retail investor outflows is the Hong Kong stock market. Mainland money entering through the Stock Connect program already accounts for around 30% of daily turnover on the Hong Kong Stock Exchange, but that is largely institutional money. A new wave of retail money could push up valuations.
Regulators may also loosen restriction on outbound foreign direct investment (FDI), which has plummeted since 2016, after policymakers tightened controls in response to a wave of trophy asset purchases by private conglomerates like Dalian Wanda, Anbang Insurance, HNA Group, and Fosun Group. But given increased political scrutiny of inbound Chinese investment in the US, Europe, and Australia, any resurgence of outbound FDI would likely flow toward developing markets.
Though incremental loosening of capital controls is likely this year, regulators have no intention to fully abandon them. Current global financial conditions support capital flows into China, which makes regulators more willing to allow countervailing outflows. But the PBoC is aware that such conditions will not last forever, so they will maintain their capability to staunch outflows if capital flight risks re-emerge.