- The renminbi has strengthened by 2.3% against the US dollar this year, raising the question of how much appreciation the People’s Bank of China (PBoC) will tolerate.
- The PBoC probably cares more about the trade-weighted exchange rate than the bilateral USDCNY rate.
- Authorities hope that the threat of currency intervention will influence expectations sufficiently that actual intervention is unnecessary.
Recent currency appreciation does not simply reflect recent weakness in the US dollar globally. Measured against the PBoC’s trade-weighted currency basket, the renminbi hit a five-year high on 28 May. Persistent large trade surpluses and capital inflows from foreign investment in China’s bond market are the key drivers of appreciation, as previously discussed.
Until now, the PBoC has appeared to use state banks as proxies to slow the pace of appreciation through small-scale, under-the-radar intervention. But at some point, authorities may decide that stronger action is necessary to protect China’s export competitiveness. The PBoC already signaled a degree of concern about excessive appreciation on 27 May when it raised the share of foreign exchange deposits that banks must hold in reserve at the central bank. By soaking up onshore forex liquidity and raising forex interest rates, this move raises the cost for investors to bet on further renminbi appreciation. The direct impact will likely be modest, but the move is a clear signal to the market that the PBoC’s tolerance for appreciation is limited.
The PBoC has probably not identified a specific level for USDCNY beyond which more forceful intervention would be necessary. Indeed, some degree of renminbi appreciation is desirable in the short term, because it buffers the impact of rising commodity prices. If the PBoC does have a red line for the exchange rate, this threshold is probably defined in terms of the trade-weighted basket. But even for this basket, the absolute level may be less important than the trading dynamic. The PBoC warned in a statement on 27 May: “The renminbi can appreciate or depreciate. No one can accurately predict the exchange rate.” The statement suggests that the main concern is that appreciation expectations may become entrenched and self-fulfilling, producing lopsided market demand.
The ideal scenario for the PBoC is that the threat of intervention exerts enough influence on expectations that following through on the threat with direct, large-scale intervention is unnecessary. Authorities would prefer to minimize intervention, which will help make onshore Chinese assets more attractive to foreign investors over the long term. Foreign inflows to China’s bond market have been strong since last year, but foreign investors are still under-exposed to Chinese bonds relative to the market’s size. While foreign investors are under no illusions that the renminbi is completely free floating, the PBoC still seeks to persuade investors that authorities are committed to exchange-rate flexibility and will refrain from competitive devaluation.
In some respects, the current situation is a mirror image of 2016 and 2017, when China’s main challenge was capital flight and uncontrolled renminbi depreciation. The PBoC allowed depreciation expectations to become entrenched in 2015 and early 2016, forcing authorities to spend roughly USD 1tn in forex reserves to convince the market otherwise. This time around, the central bank hopes that by acting early with carefully calibrated signals, authorities can avoid large-scale intervention.
If verbal guidance and macro-prudential tweaks like the forex reserve ratio fail to curb appreciation sufficiently, the next step could be re-introducing the so-called “countercyclical factor” previously used to influence the daily renminbi fixing. Authorities introduced this factor in 2017 to provide themselves with an additional tool to mitigate what they called “herd effects.” This opaque variable effectively allowed for a fudge factor allowing the fixing to diverge from the previous day’s spot close, thereby pushing back against market pressure that authorities considered irrational. The factor was suspended in October 2020 at a time when authorities were comfortable with how market forces were guiding the exchange rate. But bringing back the countercyclical factor would only be another modest technical tweak. In a scenario of more extreme appreciation pressure, the PBoC would have little choice but to intervene directly with dollar purchases, as it did for much of the 2000s and early 2010s.
In the medium term, market fundamentals may come to the rescue. Recent Covid-19 outbreaks in India and Southeast Asia are re-directing export orders from those regions to China, while also boosting demand for Chinese exports of medical supplies. When these outbreaks fade, China’s trade surpluses may diminish. Another factor is the US interest rate outlook. The large interest-rate differential favoring renminbi over dollar assets has been a key factor driving capital inflows to China. If inflation pressure forces the Federal Reserve to tighten policy faster than expected, these inflows may also diminish. The upshot is that the PBoC may only need to successfully guide expectations for a few more months before market fundamentals take the baton.