After strengthening for more than one-and-a-half years and having demonstrated resilience to global market volatility, China’s renminbi (CNY) weakened sharply in April and May. The currency depreciated 6.5% between mid-April and mid-May to CNY6.79/US$ before stabilising recently (Exhibit 1).
The CNY also fell by more than 3% against a basket of currencies over the same period. We believe the factors supporting the CNY will wane through the year.
Admittedly, attractive valuation of Chinese assets and signs of easing in regulatory tightening on the tech sector may provide fresh impetus to investing in China. However, uncertainty around Chinese businesses remains amid the risks of Chinese stocks being forced to delist from US exchanges and secondary sanctions related to Russia’s invasion of Ukraine. All of this is hurting global investors’ appetite for Chinese assets.
Exhibit 1: The renminbi has weakened sharply since April
Policy divergence between China and the US has become starker since March as the US Fed turned very hawkish, at a time when China’s policy became more accommodative. The 10-year US Treasury yield rose from below 2% in early March to over 3% in mid-June. In contrast, the 10-year Chinese bond yield has remained largely steady (at around 2.8%) in the past few months. The China-US 10-year yield spread turned negative as a result—the first time since 2010. This has made Chinese bonds look unattractive—leading to a reduction in foreign bond holdings and the CNY weakening.
Exhibit 2: Portfolio outflow pressures drove the CNY weaker
Outflow pressures will remain in the second half of 2022
Besides negative China-US yield spreads, we believe regulatory risks, the uncertain economic outlook due to China’s “dynamic zero-COVID” policy, and concerns about the effectiveness of macro policy easing are the reasons to think that capital outflow pressures and CNY weakness will likely remain in the second half of the year.
Moreover, the risk of Chinese stocks being forced to delist from US exchanges is looming—the process could begin as soon as early 2023. While it is still possible that China and the US will reach an audit deal, time is running out and it looks inevitable that some Chinese companies will be delisted from the US. This doesn’t bode well for global investors’ appetite for Chinese assets.
There could be some optimism about the CNY due to a partial dial back of US tariffs on Chinese products as early as July, though the whole review process will likely take months. However, tariffs on most products will still likely remain. More generally, the risk of decoupling (especially on the technology front) and heightened geopolitical risks will continue to dampen the appetite for Chinese assets.
China’s tech sector, however, may get a breather from the regulatory crackdown by the Chinese authorities, which should at least help reduce capital outflow pressures. But any easing of crackdowns is not likely to be significant and will have little real economic impact in the near term.
An uncertain growth outlook
China is prioritising COVID containment and while the authorities want to support the economy, there is significant uncertainty around its growth outlook. Although we forecast China’s economy to recover in the second half after a quarterly contraction in the second quarter as activity returns to “normal” following the Shanghai lockdown, we believe risks to our outlook are tilted to the downside.
The effectiveness of policy stimulus will largely depend on the scale of future COVID outbreaks and restrictions. Global investors’ appetite for Chinese assets will unlikely rebound substantially this year, given China’s growth outlook will still be highly uncertain due to the zero-COVID policy.
We forecast the renminbi to remain weak and it could hit CNY6.8/US$ in the second half (from CNY6.65-6.79 in May) before a rebound in 2023, assuming China’s economy will be on track to recover and moves beyond its zero-COVID policy next year.
Nonetheless, the recovery process is far from certain. In an extended lockdown scenario, we assess the impact of harsher and longer mobility restrictions. The consequences would be further falls in consumption and more severe supply chain disruption than we have assumed in our baseline, causing China’s growth to fall to just 1% this year (Exhibit 3). The CNY would weaken by another 3% against the US$. Based on our current forecast, this implies the renminbi would weaken beyond CNY7/US$ in the second half under the downside scenario.
Exhibit 3: In an extended lockdown scenario, China’s GDP could fall to just 1% this year
However, if China significantly reduces COVID-related restrictions next year, there is still a good chance of a rebound in global demand for Chinese assets. Even though the outlook for certain sectors will probably remain gloomy due to decoupling and regulatory risks (such as the tech sector), other sectors could recover strongly and attract foreign investment. The game-changer would be if China could move beyond “zero-COVID”.
The central bank’s policy stance
Despite steep CNY depreciation in recent months, the People’s Bank of China (PBoC) has refrained from direct intervention in the FX market. Policymakers probably don’t mind the currency remaining weak for a while, as it will help boost exports and support the economic recovery in the second half of the year. But a depreciating CNY adds to import bills and will hurt producers, meaning any significant further weakening of the CNY would be unwanted.
We think the PBoC will likely continue to refrain from direct intervention. The authorities prefer not to use the FX reserves after they used $1 trillion (a quarter of the $4 trillion FX reserves at its peak) to defend the currency back in 2015-2016. However, we think the central bank will use other policy tools to stabilise the exchange rates when necessary. The PBoC could further lower banks’ FX reserve ratio (it was last lowered in April), and even reinstate the countercyclical factor into the renminbi daily fixing formula if the CNY weakens significantly further, particularly when the CNY reaches the 7-mark against the US$.
What about other factors?
We think a shrinking current account surplus points to a weaker CNY in the second half of the year. While the current account surplus remains sizeable, we expect it to shrink in the coming months as export demand will likely remain weak. Meanwhile, import demand could recover amid strong policy stimulus feeding through—notably the demand for commodities related to infrastructure investment.
Inward foreign direct investment (FDI) rose markedly in January-May, although the economy had already started weakening in the first quarter (Exhibit 4). We think FDI will slow in the coming months as many foreign companies pause their plans to invest in China due to the uncertainty created by the zero-COVID policy—particularly after the Shanghai lockdown heavily disrupted domestic supply chains.
Exhibit 4: FDI inflows have been strong despite the weakening economy
Broadly speaking, it is unlikely the renminbi will rebound this year, particularly as there is little to suggest the global demand for Chinese assets will increase substantially. Things may turn a corner once China significantly eases COVID-19 restrictions, but not until then.