One of the major events in the Chinese market recently was the depreciation of the RMB against the USD. The RMB’s rapid decline against the USD started in the offshore market. From the closing price of 6.3788 on April 18 to the 6.6000 on April 25, the offshore RMB depreciated more than 3% against the USD in just five trading days. The depreciation of the RMB spot exchange rate against the USD started on April 20, from the closing price of 6.3778 on April 19 to the closing price of 6.5544 on April 25, depreciating more than 2.7% in just four trading days.
Faced with a sharp drop in the RMB against the USD in both offshore and onshore markets, the People’s Bank of China (PBoC) stepped in to intervene. On the evening of April 25, the PBoC has decided to lower the foreign exchange reserve requirement ratio (RRR) for financial institutions by one percentage point from the current 9% to 8% starting May 15, 2022, in a bid to improve their ability to use foreign exchange funds.
Lowering the foreign exchange reserve requirement ratio of financial institutions will increase the fund supply of foreign exchange loans of financial institutions, aiming to stabilize the RMB exchange rate. At the end of March, China’s foreign exchange deposits stood at USD 1.05 trillion. A 1 percentage point cut in the foreign exchange reserve requirement ratio is equivalent to a USD 10 billion reduction in financial institutions’ foreign exchange reserve requirements. Since last year, the PBoC has frequently used the foreign exchange reserve requirement ratio as a tool to guide market expectations. Previously, in the face of the continuous appreciation of RMB against USD, the PBoC raised the foreign exchange reserve requirement ratio twice in 2021. On May 31 and December 9, 2021, the PBoC announced to increase the foreign exchange reserve requirement ratio of financial institutions by 2 percentage points, and the foreign exchange reserve requirement ratio was raised from 5% to 9%. After the PBoC’s moves, the continuous appreciation of the RMB against the USD was brought under control.
Figure 1: Offshore RMB continues to fall against the USD
This time, the market also responded to the PBoC’s move to lower the foreign exchange reserve requirement ratio. On April 25, the RMB spot exchange rate against the USD, which once depreciated to the 6.57 mark, recovered the 6.57, 6.56, and 6.55 marks in quick succession. This was also reflected on international investors, with the offshore USD/RMB exchange rate recovering 6.60, 6.59, and 6.58 marks in quick succession, closing at 6.5701 on the same day. However, on April 26, the offshore RMB fell again. The RMB exchange rate fell to 6.5759 again at about 16:00 on April 26, Beijing time. The onshore RMB edged up 0.0869% to 6.5536.
In fact, the offshore RMB market in Hong Kong, with a pool of offshore RMB funds of about RMB 1 trillion (more than USD 150 billion), is a manageable market. While the offshore market is more reflective of international market’s view of the RMB exchange rate, i.e., it is closer to “market reality,” it is still a manageable market. In fact, the PBoC has influenced the offshore RMB exchange rate by adjusting the supply of RMB in the Hong Kong market during the past sharp fluctuations in the RMB exchange rate. As for the onshore RMB exchange rate, it is even more amenable under a managed floating exchange rate regime.
According to researchers at ANBOUND, the issue of the RMB exchange rate is a major issue under the current circumstances. For China, the rise and fall of the RMB is a sign, and what worries regulators most is the substantial damage done to the RMB and the domestic market by a massive outflow of funds from the mainland market that is rapidly depleting foreign exchange reserves. It is worth noting that the momentum driving domestic capital outflows is accumulating under the current international trend and the condition within China itself.
Contrary to the views of many research institutions, we believe that the RMB exchange rate issue is not simply a financial market matter. In the medium to long term, what affects the RMB exchange rate is not at all any market factors of a technical nature, but two macro factors based on international and domestic situations.
Internationally, the most significant factor is geopolitics. In the context of the war in Ukraine, Russia is still able to convert the RUB into USD indirectly through a “soft” peg between the RMB and the USD, and the U.S. would certainly be aware of these possibilities and would not allow Russia to use the RMB as a way to circumvent sanctions. Therefore, from the U.S. perspective, the RMB would have to be depreciated, which would reduce Russia’s incentive to convert RUB into RMB. The RMB exchange rate is under pressure due to geopolitical factors, and this is a situation that is difficult for China to circumvent at the moment.
Domestically, the most significant factors have been the pandemic and the economic slowdown it has caused, as well as the withdrawal of capital from China. The spread of COVID-19 in many places in China has brought considerable uncertainty to the Chinese economy. Take Shanghai as an example, as the leading city in the Yangtze River Delta region, it was the first time in history that the city was locked down for nearly a month (some areas were locked down for more than 50 days). Based on 2021 standards, the local GDP affected so far is estimated to be more than RMB 300 billion. If Shanghai were to lock down for another month, it would be a disaster for both the city and the Chinese economy. The outbreak has been followed by strict precautionary measures around the country as well as transportation blockages, all of which have caused the impact of the outbreak to spread across the country. Now, Shanghai is still under lockdown and the pandemic situation in Beijing is getting worse, which will further worry the market. From an objective point of view, the strict prevention and control measures implemented for a long period of time have already dealt a considerable blow to market confidence. We have noticed that many foreign and domestic investors are reassessing policy risks in the Chinese market. In the capital market and related industries, some short-term, long-term, foreign, and domestic capitals are considering withdrawing from mainland China. This situation is another important factor contributing to the depreciation of the RMB.
We would like to stress that the key factor influencing the RMB exchange rate is no longer market factors, but geopolitical and domestic macro policy issues. Therefore, one should not respond with conventional thinking and practices in the face of sharp fluctuations in the RMB exchange rate. While measures such as the foreign exchange reserve requirement ratio cut may mitigate RMB depreciation in the short term, they won’t address the main risks facing the RMB. The main factors affecting the RMB exchange rate are not the pool of capital in the offshore RMB market in Hong Kong, but the larger international and domestic political and economic environment. Without a grasp of these core factors, China’s response policies may struggle to address the main problems.
It should be noted that geopolitical factors and the domestic pandemic are simultaneously forming a confluence effect on the RMB exchange rate. If this pattern does not change significantly, it will be a medium to long-term constraint on the RMB. In the face of this possible trend, how will the country adjust its policies? The most ideal situation for China is that both domestic and international factors are adjusted, geopolitical influence is reduced, and the domestic economic fundamentals are improved due to the improvement of the pandemic situation and relaxation of lockdown. However, these two factors do not depend on the domestic financial policy department. From the perspective of the three factors involved in the “impossible trinity”, i.e. free capital flow, fixed exchange rate, and sovereign monetary policy, it is likely that the domestic financial policy department will restrict the free capital flow and foreign exchange outflow with “hard” administrative measures. However, this would seriously exacerbate market fears and capital outflows and lead to de facto financial decoupling. Faced with such a possible scenario, the authorities concerned should plan carefully.
Final analysis conclusion:
The factors affecting the RMB exchange rate are becoming increasingly complex, and the recent sharp depreciation of the RMB shows that the market is worried about the future trend of the RMB under the influence of international geopolitics and the COVID-19 outbreak within China. In order to mitigate the continued depreciation of the RMB, more “hard” measures might be taken by the Chinese policymakers in the future to reduce capital outflows.
Writer by He Jun
Partner, Director of China Macro-Economic Research Team and Senior Researcher. His research field covers China’s macro-economy, energy industry and public policy.
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