Macro Point: Where To Go From The RMB Exchange Rate?

In recent months, the substantial increase in foreign trade surplus is an important driver behind the appreciation of the renminbi.

Weak domestic demand and falling commodity prices dragged down imports, so the trade surplus in 7 and August was record high ($47 billion and $50 billion respectively).

In fact, in the past four months, when the General Administration of Customs released a higher foreign trade surplus, the central bank would correspondingly promote the appreciation of the central parity of RMB (Figure 2).

In the year to 2015, we expect that exports will continue to moderate recovery and imports will remain weak, so the trade surplus will probably remain relatively high.

With the expansion of foreign trade surplus, the political pressure on the us to ask for further appreciation of the renminbi will increase.

Although the RMB effective exchange rate has appreciated nearly 30% since 2007, and the share of current accounts for GDP has dropped from 10% to 2% in 2013, the pressure of appreciation from trading partners has never been reduced.

We expect that this appreciation pressure will continue to affect China's exchange rate policy.

Foreign monetary conditions are loose and the cost of capital is low, while domestic credit has some controls and interest rates are relatively high. In recent years, capital inflows have been increasing, and the scale of Chinese enterprises' overseas loans has increased significantly.

Capital inflows in some sectors (such as easing foreign debt management), increased cross-border RMB settlement, and a steady appreciation of the renminbi over the past few years have further exacerbated capital inflows.

Although interest rate differentials between domestic and foreign countries have declined (Figure 3), the demand for overseas financing of Chinese enterprises has not diminished, and we expect further opening of capital accounts.

The promotion of RMB internationalization by policy makers also brings appreciation bias to the renminbi, because the depreciation of the renminbi may reduce its attractiveness in the international market.

Considering the current economic slowdown, high financial risk and imperfect segmentation of the bond market, and considering the current situation of monetary policy management, there are voices in the market questioning why we should promote internationalization of the RMB and maintain a stronger exchange rate at this stage.

However, the internationalization of RMB is one of the objectives of decision making in the next few years.

In addition, in order to maintain a stable domestic liquidity environment, policymakers may also want to maintain a stable exchange rate so as to avoid a significant devaluation of the renminbi, resulting in capital flight and domestic liquidity.

So a few months ago, when the closing price of the yuan continued to be weaker than the middle price, the central bank seemed to have sold dollars to help stabilize the RMB exchange rate.

Although these factors support the appreciation of the renminbi, we believe that the factors that support the depreciation of the renminbi may have a slight advantage.

First of all, although the recent trade surplus has risen sharply, we believe that the balance of RMB is approaching the equilibrium level from the fundamentals of the balance of payments.

After a steady appreciation in the past few years, China's unit labor cost has risen sharply relative to its main trading partners (Figure 4).

Our estimated cyclical adjusted current account surplus has dropped to around 3% of GDP (see our March 27th report "losing competitiveness or upgrading the value chain - dialysis of China's export competitiveness"), which is close to the equilibrium level corresponding to China's savings investment balance.

In addition, the main factor contributing to the substantial increase in foreign trade surplus is the decline of domestic real estate market and the contraction of imports, rather than the enhancement of China's export competitiveness.

Second, although policies continue to be overweight, China's economic growth is weak, and domestic demand may decline further next year, so it may rely more on exports to support employment and ease the economic downturn.

Although exports have been recovering moderately in recent months (an increase of about 9% over the same period last year), they have only increased by 5% over the same period since the beginning of the year, and the prospects for the recovery of the global economy in the future are still uncertain.

Under such circumstances, the decision-making level may not further push forward the appreciation of the renminbi.

Third, in the context of the appreciation of the US dollar against other major currencies, even if the exchange rate of RMB against the US dollar remains unchanged, the effective exchange rate of a basket of currencies for major trading partners will also appreciate accordingly.

If the policymakers want to keep the effective exchange rate unchanged, they will have to allow the renminbi to depreciate against the US dollar in the next two years.

In addition, as policy makers push ahead with social security reform and energy price reform and enforce more stringent environmental standards, rising domestic factor prices may also push up China's real exchange rate.

Finally, due to the decline in real estate activities and the rising interest rates abroad, domestic interest rates are expected to decline, residents' overseas investment demand will increase, and capital controls will gradually relax, which will lead to more capital outflows in the coming year.

Although the trade surplus in 7-8 months has been growing rapidly, foreign exchange accounts for domestic financial institutions have not increased very much, and it has also proved that capital outflow may start from the side.

In addition, the appreciation of the renminbi is expected to be relatively low and has dropped sharply since the beginning of the year (Figure 5&6), which is also one of the reasons for the capital outflow.

Taking all these factors into consideration, we expect that the RMB exchange rate against the US dollar will not show a trend of appreciation or depreciation in the next two years.

Considering that China's economic growth is slowing and the US dollar is strong, we expect that the yuan will depreciate slightly against the US dollar.

We expect that the exchange rate of the RMB against the US dollar will reach 6.20 by the end of 2014 and reach 6.35 by the end of 2015.