Although the CNH exchange rate stabilized for a few sessions after the PBoC governor Yi Gang’s speech on July 3, which vowed to keep the RMB exchange rate relatively stable, it showed signs of accelerated depreciation again in recent days. Not only has the CNY, the world’s second largest currency by trading volume, depreciated against the USD, it had also boosted the dollar index – we observed synchronized weakness of major currencies amidst the RMB’s weakness, while the downward pressure on EM currencies appears more pronounced. Following our note on the recent development of the CNY published on June 28, we update our readers on the potential (short-term) factors behind the RMB weakness in the recent sessions. We also share our thoughts on how it may evolve going forward.

As we have discussed in our previous note, short-term factors driving the RMB weakness include narrowed China-US interest rate differential, the negative (psychological) impact from the Sino-US trade war, and the concentrated FX purchase need for dividend pay-out in July-August. In this note, we highlight 2 more factors that may have led to a shift in the demand-supply dynamic of the RMB in the short term:

The regulations over FX debt issuance of Chinese corporate have tightened visibly since end-June, while a large number of FX debt started to mature in July. In addition, since we witnessed a notable acceleration of Chinese corporate FX debt issuance when USD/CNY appreciated to ~6.70 previously, the demand to “hedge for” or “unwind” these de facto “long CNY/ short USD” positions may rise when CNY falls below 6.70 vs. the dollar. The NDRC loosened the regulation for overseas FX debt issuance by changing the issuance process to registration-based from approval-based for FX debt with duration < 1 year on September 2015 (when China was under sizable FX outflow pressure). In the same guideline, the NDRC also encouraged corporate to issue more FX denominated debt. Two and half years later in May 2018, the NDRC started to tighten regulations over overseas FX bond issuance. More recently, the NDRC issued document No. 706 on June 28, which dialed up the scrutiny over FX debt issuance by property developers and local-government affiliated companies. It was also reported by media on the same day that the NDRC tightened regulations over the issuance of 364-day FX denominated debt. We have observed a notable slowdown of FX debt issuance since June 28. However, the amount of maturing FX bonds started to pick up notably in July 2018. With rising debt repayment pressure and tightened regulation over FX bond issuance, some of the issuers may be forced to unwind part of their FX debt, which is equivalent to selling RMB and buying FX in practice. In addition, we observed a visible pick-up in FX bond issuance when USD/CNY appreciated to ~6.70. Understandably, the demand to hedge for or unwind some of these de facto long CNY /short USD positions (by borrowing USD to invest onshore) may be triggered as well.

Rising volatilities in the domestic capital markets may have also reduced the inflows to or triggered outflows from the mainland & Hong Kong markets – the correlation between the the CNY and the domestic equities market has spiked in recent weeks . The foreign investors held RMB 1.2 trillion of mainland-listed equity assets as of March 2018, RMB 0.5 trillion higher than the value in early 2017. In addition, cumulative north-bound inflow (via Shanghai-Shenzhen-HK stock connect) amounted to RMB 507 bn. We have picked up some early signs of reduced risk appetite of overseas investors towards Chinese equities listed in both mainland and HK since June, as evident in the recent fund-flow data – HK market has already seen net outflows in recent weeks, while the northbound inflow via SH-SZ-HK stock connect has withered as well. Understandably, dampened sentiment towards investing in China’s capital markets has also reduced the incremental demand for the RMB.

The policy “flip-flop” over FX debt issuance and the reduced interest in allocating towards China-related assets has both added to the incremental selling pressure of the RMB. However, there are 3 key differences between this round of CNY weakness vs. the episode in 2015-16 – 1) there appears to be no intention to guide the CNY lower by the PBoC; 2) we are yet to see large-scale FX outflows; and 3) there appears to be less speculative “short-sellers” for RMB this time round. Firstly, we maintain that the monetary authority appears to have no intention to guide the CNY lower, since we have not observed any sizable deviation of CNY central fixing vs. our “forecast value” in recent weeks. However, it is worth noting that the central fixing formula of the CNY is “pro-cyclical” by nature, i.e. with the previous day’s closing as one of the key determinants of the central fixing the next morning, the time series of CNY exchange rate will likely be auto-correlated. On the other hand, although we have observed some pick-up in onshore CNY transaction volume since June, we have yet to identify any concrete signs of FX outflows. According to the latest PBoC balance sheet data (in June), FX assets held by the PBoC has increased MoM in June. In addition, one interesting observation is that, different from the episodes in 2015-16 when China suffered considerable monthly FX outflows, the CNY NDF hardly moved this time round, indicating that there may be less “speculative” short-sellers during this round of CNY depreciation. In retrospect, these observations prompted us to investigate upon the potential “real demand” to sell CNY in this note.

Although the current depreciation expectations of the RMB and the consequent FX outflow pressure is considerably less pronounced than they were in 2015-16, but we believe it is worth reiterating that policy makers should take efforts to prevent the RMB depreciation expectations from building up further. Further deterioration of sentiment towards the RMB may send the FX rate, capital markets, and the real economy financial conditions into a negative feedback loop. Overlapping policies targeted at “deleverage” has already resulted in significant tightening of the financial conditions, the lagged effects of which includes downwards pressure on growth, inflation, earnings, and corporate cash flow. In our view, it is time for decisive policy adjustments to “neutralize” the policy setting and prevent further deterioration of growth expectations. In this regard, keeping exchange rate stable is a key part of anchoring market expectations. Unique to China’s situation of controlled capital account and managed exchange rate, RMB NEER depreciation may not necessarily loosen domestic monetary conditions. Letting RMB slide slower when sentiment is already weak on the currency may trigger FX outflows and dampen base money growth, which is highly contractionary and will most likely add to the complexity of the current macro policy adjustments, including the management of domestic interest rate and RRR. However, that said, China’s domestic policy should prioritize their own cyclical management targets, instead of being constrained by the exchange rate concerns.

In our view, there is slim chance of a “free-fall” of CNY exchange rate, mainly driven by our more benign view regarding further upside for the USD index. In the short term, the PBoC may anchor the RMB exchange expectations by actively communicating with the market, and/or lifting the central fixing using positive “counter cyclical factor”. In the medium-long term, however, the stabilization of the CNY exchange rate hinges on China’s growth trajectory and the market expectation on China’s economic performance. Looking beyond the short term factors, the relative strength of China’s currency is ultimately driven by the expected investment returns in China. In the meantime, the correlation between FX and equity market volatilities has picked up visibly in recent weeks. All considered, anchoring the expectation for China’s growth, corporate profitability, and asset quality is likely the most effective way to stabilize the RMB exchange rate expectations. In this regard, decisive and coordinated policy adjustments to prevent continued tightening of financial conditions hold the key in easing the pressure on the RMB. On the execution level, the directions of the adjustments include a neutral monetary policy setting, more accommodative fiscal stance, and more pragmatic regulatory guidelines. The execution guides for asset management industry published last Friday marked a positive step towards more pragmatic and actionable regulatory environment.