During the “Two Sessions”, China’s Premier Wen Jiabao and the State Administrator of Foreign Exchange Yi Gang both said that the Renminbi might be close to the “equilibrium” level. This top-level comment could probably mark a much lower Renminbi appreciation this year and the advent of RMB’s two-way floating process. Last September, the long-standing consensus of one-way Renminbi appreciation was challenged for the first time since 2005 when the PBoC allowed Renminbi to appreciate against USD. Afterwards, in the onshore market, USDCNY hit lower trading bound set by the PBoC for 12 consecutive days in December; FX purchase by the banks dropped for three straight months in Q4. In the offshore market, the non-deliverable forward (NDF) indicated no appreciation expectation or even depreciation expectation; the Hong Kong Renminbi (CNH) traded at a discount of onshore Renminbi while it used to trade at a premium. Many people believe that the balance of payment, especially the trading account, is the only significant factor behind the FX purchase and the expectation of Renminbi exchange rate. However, although trading account is an important factor, there are other issues that affect the FX purchase and the Renminbi market. We believe that it is primarily the dollar short-cover actions of the exporters and importers that caused the Renminbi depreciation pressure in the last quarter of 2011 and trading account is just a minor issue. To understand this, we have to review the FX flow framework in China first.
In order to understand the FX flow framework, we consider the following simplified model, which focuses on the core part, exports and imports, and disregards direct investments, dividend payments or offshore capital raising (they actually work in similar ways). The following chart shows the FX inflow framework related to goods export; vice versa for outflow.
Note: we use USD as a representative of all FX, as most of China’s external trades are settled in the USD.
There have been two remarkable changes in this framework since last September. Firstly, foreign companies adjusted their Renminbi position. As shown in the model, the foreign company, a combination of exporter and importer, could choose to settle trades in USD or Renminbi. Before Sep 2011, the foreign companies with a long-Renminbi bias preferred to receive in Renminbi and pay in USD, leading to an evident imbalance in Renminbi receipt/payment of trade settlement. However, the foreign companies suddenly tended to pay in Renminbi and receive in USD since last Sep, which showed that they preferred to short Renminbi and long USD. Consequently, the RMB settlement receipt/payment ratio shifted from 1:2.2 in Jan-Aug 2011 to 1.4:1 in Sep-Dec of 2011, but the overall ratio in 2011 was still 1:1.3 (it was 1:5.3 in 2010).
Secondly, Chinese exporters and importers also adjusted their appreciation bias on the Renminbi. In the past few years, the Chinese companies would immediately sell USD to banks after they received the payment, and it had followed a financial strategy of “assets in RMB, liabilities in USD”. Since September 2011, however, we’ve seen a reversed trend. Exporters tended to hold USD assets and repay USD loans. As a result, bank deposits denominated in USD increased much faster than loans denominated in USD. This is proved by a report from State Administration of Foreign Exchange (SAFE). According to the SAFE report, bank deposits denominated in USD increased by 7bn monthly on average in Q4, much higher than Q1-3’s average of 2bn; meanwhile, loans denominated in USD increased only by 1bn monthly in Q4, much lower than Q1-3’s average of 7bn.
The following chart shows three sets of data: trade account balance, cross-border receipt/payment balance for goods, and banks’ FX selling/buying balance for goods. While all of them have impacts on the onshore Renminbi market, the banks’ net FX position change affects directly to the FX purchase number. From the chart we can see that the net export surplus stayed quite stable in the second half of 2011, but the cross-border trade settlement and banks’ net FX purchase position changed dramatically.
The difference between cross-border receipt/payment balance (red line) and trade balance (blue line) measures the advance or delayed payments of goods from both domestic and foreign companies. This difference was mostly positive before September 2011 because Chinese importers tended to delay US dollar payments (so that they can benefit from Renminbi appreciation). However the trend reversed after September and the Chinese importers speeded up the dollar payments.
The difference between banks’ net FX purchase balance (green line) and cross-border receipt/payment balance (red line) largely measures Chinese companies’ net FX funding from domestic banks, and it also suggests the Renminbi receipt/payment balance. This difference turned from positive in Q1-3 2011 to slightly negative in Q4, as Chinese companies reduced dollar-denominated liabilities and increased dollar-denominated assets, and net Renminbi inflow increased because foreign companies no longer preferred to hold Renminbi.
Taking all into account, the Renminbi depreciation trend happened in late 2011 was primarily because the exporters/importers changed their view on the Renminbi exchange rate, and this shift is triggered by the worseness of European debt crisis and concerns on China’s hard-landing. Under that circumstance, companies preferred to hold assets denominated in riskless currencies (US Dollar and Japanese Yen) rather than assets denominated in risky currencies (Euro, Asian currencies including the Renminbi). Looking forward, this depreciation trend may reappear as European debt crisis may deteriorate even further. The shrinking of China’s trade surplus can also cause some bets of Renminbi depreciation, but the decrease of net exports does not necessarily lead to the weakness of Renminbi. Chinese companies have accumulated huge dollar-short position in the past few years to benefit from the Renminbi appreciation. When they restart to adjust their balance sheet currency mismatch, like what they did last year, Renminbi will see another depreciation pressure. Last but not the least, the dollar short-cover actions by Chinese exporters and importers will undermine the monetary creation ability of the PBoC and the deposit growth is likely to miss the target.
Chen Long and Lin Qiaowei
Central Banking Seminar
