• With inflation poised to drop sharply and increasing downside risk to growth, we expect the pace of appreciation of the CNY against the USD to slow to around 3% over the next year, from more than 5% over the past year. In our view, we remain far from a situation where China will temporarily ‘re-peg’ to the USD as in late 2008.
• Appreciation expectations in the market have now largely been removed and in the offshore market the forward curves for USD/CNY and USD/CNH are now
upward sloping and discounting a slight depreciation of CNY over the next year.
• Hence, it now looks cheap to hedge CNY expenditures. The new offshore market in Hong Kong currently offers a particularly favourable pricing compared with the NDF offshore market and the onshore market in China.
• For investors, we recommend selling USD/CNY NDF. However, because
financial markets are likely to remain volatile in the short run, it could be some
time before the market starts to discount continued appreciation again. For this
reason, we prefer selling maturities beyond six months.
• While we expect the gradual appreciation to continue, we also expect to see
increasing two-way volatility in USD/CNY. There are signs that the People’s
Bank of China is increasingly using the space within the +/-0.5% daily trading
band, which might be widened at some stage next year.
Policy moving in a more growth-supportive direction
We expect economic policy in China to become more growth supportive in the coming months after having been focused mainly on containing inflation since early 2010. The main reason is that inflation is poised to fall sharply in coming months. CPI inflation declined from 6.1% y/y in September to 5.5% y/y in October and we expect it to plunge further to 4.4% y/y in November. The PBoC’s inflation target for 2011 as a whole is 4%. It is possible that the inflation target for 2012 could be cut slightly to 3.5% when it is announced in connection with the Central Economic Work Conference (usually held in mid-December). Our current forecasts suggest that inflation could decline below 3.5% as early as March 2012 and hence we do not expect inflation to be a major constraint on monetary policy in early 2012.
Another important target for China’s monetary policy is growth in bank loans and M2 money supply. That said, earlier this year PBoC announced that it would gradually start to target a broader credit measure (total social financing) that includes sources for credit expansion other than just bank loans. For this reason, PBoC has started to put more weight on M2 growth and less weight on bank loans in its decision making. The target for M2 growth in 2011 is 16% and we think this 16% for M2 growth will be maintained for 2012. However, PBoC is currently undershooting its 16% target for M2 growth substantially. This also suggests that PBoC should now have some room to ease monetary policy.
Recent activity indicators for economic activity (mainly manufacturing PMIs) have disappointed and suggest increasing downside risk to our growth forecast. According to our calculations, GDP growth was 6-7% q/q AR in both Q2 and Q3. This is below the 9% GDP growth that we estimate is China’s current potential growth. As can be seen in the chart on page 1, our current forecast assumes that GDP growth will improve in the current quarter. However, the weakness evident in both of China’s manufacturing PMIs suggests that growth will be weaker than we currently expect. Manufacturing PMIs in the 47-49 range indicate that that GDP growth will remain subdued in the 6-7% q/q AR range in Q4 11. Hence, we will probably have to lower our GDP forecasts for Q4 11 and Q1 12.
Based on this development, we expect economic policy in China to move in a more growth-supportive direction in the coming months. Credit growth will gradually be allowed to pick up after having been below trend in recent months. To support this development, PBoC has already cut the reserve requirement ratio (RRR) for commercial banks by 50bp. We expect the RRR to be cut twice, by 50bp in Q1 12 and 50bp in Q2 12. At this stage, we do not expect PBoC to cut its leading deposit and lending rates. It is possible that fiscal policy will also be eased slightly (construction of social housing the main tool) but, at this stage, we are unlikely to see a significant fiscal stimulus similar to late 2008 in the wake of the collapse of Lehman Brothers.
Appreciation pace poised to slow
A slower appreciation of CNY is likely to be part of a more growth-supportive approach to monetary policy. However, inflation appears to be more important than economic activity for the pace of appreciation. As seen in the top chart, in recent years there has been a close relationship between inflation and the pace of appreciation in the sense that the pace of appreciation tends to increase when inflation increases. Hence, our expectations of markedly lower inflation also suggest the pace of appreciation should ease.
Currently our model for the pace of appreciation of CNY against USD suggests that appreciation should slow to around 3% annually, from more than 5% over the past year. Besides current inflation, the pace of appreciation in our model is explained by past changes in the effective exchange rate. It appears that if the effective exchange rate appreciates significantly, then the pace of appreciation against the USD tends to slow in the following months. This suggests that China to some degree targets the effective exchange rate. In other words, if for example other Asian countries depreciate against the USD (and the effective CNY exchange rate appreciates), then China will tend to slow the appreciation of the CNY against the USD in the following months.
Appreciation expectations have been removed in the market
In the market, appreciation expectations have largely been removed in recent months. For the first time since March 2009, the 12-month USD/CNY on-deliverable forward (NDF) has since late September been trading slightly above the spot USD/CNY exchange rate. Both offshore market forward curves are now upward sloping and discount a slight depreciation of the CNY against the USD (see bottom chart). The NDF market now discounts a 0.8% depreciation over the next year while the offshore market in Hong Kong discounts a 1.3% depreciation. The onshore market in mainland China discounts a small 0.2% depreciation against the USD.
With the market no longer expecting the CNY to appreciate, it is, in our view, discounting a relatively hard landing of the Chinese economy similar to the one China experienced in the wake of the global meltdown in late 2008. China’s response in 2008 was to stop the gradual appreciation against the USD and ‘re-peg’ to the USD until spring 2010. As can be seen in the chart above, our model for the pace of appreciation actually suggests that China should depreciate the CNY at that stage. However, the Chinese leadership is aware
of the significant political and economic implications of a depreciation of the CNY under those circumstances. First, it could infuriate the US in particular and risk a trade war, because for the US there is a big difference between China not appreciating enough and actually starting to depreciate its currency. Second, just as in the wake of the Asian crisis in 1997, the Chinese leadership also judged that a depreciation of its currency would have few benefits for the economy, as it would only destabilise financial markets further and prove counterproductive for the Chinese economy. So, if China’s growth for some reason slows substantially, China’s crisis response is likely to stop the gradual appreciation temporarily, as in 2008.
With the market no longer expecting any appreciation, it does, in our view, already discount a very negative macroeconomic scenario similar to that in 2008. However, although the economic indicators have disappointed recently, they still suggest the Chinese economy is far from a situation as severe as after the financial meltdown in late 2008. After the slowdown in 2008, inflation bottomed at -1.9% y/y in July 2008. For comparison, inflation is currently above 4% y/y, albeit we suspect it could decline below 3% y/y in mid-2012. From late 2007 until November 2008, the effective CNY exchange rate appreciated by a notable 18%. So far, the effective CNY exchange rate has only appreciated by about 3% since the beginning of 2011. Finally, China’s two manufacturing PMIs plunged to the 39-41 range in the wake of the financial meltdown in 2008 whereas they are currently in the 47-49 range. The bottom line is that economic data suggests that there still is a substantial buffer before China will consider abolishing its gradual appreciation policy.
Trading band could be widened and two-way volatility increase
In a notable development in the FX markets, there are signs that PBoC is increasingly using the space it has within the daily trading band and allowing more two-way volatility in the USD/CNY exchange rate. In China the daily changes in the USD/CNY exchange rate have to be kept within the +/-0.5% daily trading band. The daily trading band is fixed daily relative the reference exchange rate fixed by PBoC every morning before trading starts. As can be seen in the chart, the reference exchange rate has, until recently, been fixed as the previous day’s close and, in general, PBoC has not really used the space it has within the daily trading band. However, this appears to have changed. In recent weeks, spot USD/CNY has been trading very close to the upper ceiling. This suggests there has been domestic selling pressure on CNY and, according to press reports, we are currently in the extraordinary situation where PBoC has been selling USD to keep USD/CNY within the trading band. This suggests that China’s accumulation of FX reserves is easing fast. As seen in the top chart, this was already evident in Q3 and we would not be surprised if China’s FX reserves turn out to have declined in Q4. The decline in FX reserves is due to a reversal of the ‘hot money’ inflows that have to a large degree been driven by appreciation expectations. However, we expect appreciation expectations to return to the market and hence the reversal of “hot money” inflows should prove temporary, although the appreciation pressure could slow substantially in the short run, given the reversal of ‘hot money inflows’ and the selling pressure on CNY.
We also regard PBoC’s recent selling of USD and keeping the reference rate substantially below the previous day’s close as a commitment from PBoC to avoid of depreciation of the CNY. However, it also suggests that PBoC is increasingly willing to use the space it has within the daily trading band. Although we expect the CNY to continue to appreciate, we should probably also get used to more two-way volatility in the exchange rate. This development reflects China’s gradual move towards a floating exchange rate. In our view, the Chinese government is targeting a floating and fully convertible currency by 2015. This is likely to be a gradual process and the next step is likely to be a widening of the daily trading band, which, in our view, could happen as soon as next year.
Yuan is now cheaper in the offshore market
Another notable development in the FX market in recent months is that the Chinese currency is now cheaper in the offshore market in Hong Kong (Chinese currency traded offshore in Hong Kong is called CNH). As can be seen in the chart, USD/CNH now trades above USD/CNY (the onshore exchange rate). This is the first time since the offshore market was established last year that the Chinese currency is cheaper on the offshore market.
The Chinese currency has previously been slightly more expensive in the offshore market due to strong demand for CNH-denominated assets in the offshore market (particularly CNH-denominated bonds) due to the appreciation in the market. However, as appreciation expectations in the market have gradually disappeared in recent months, there has also been a sell-off in CNH-denominated assets and this has weakened CNH. As can be seen in the second chart, the premium between the offshore USD/CNH exchange rate and the onshore USD/CNH is closely correlated to major changes in appreciation expectations in the sense that when there are significant appreciation expectations in the market the Chinese currency will tend to be more expensive on the offshore market and reverse if there are depreciation expectations in the market. Importantly, the premiums between the offshore and onshore exchange rates are likely to narrow over time due partly to ‘arbitrage’ from foreign trade payment.
Because we expect the market to start discounting some appreciation of CNY at some stage next year, we also expect the offshore-onshore premium to reverse so that the Chinese currency will again be slightly more expensive in the offshore market (USD/CNH will trade slightly below USD/CNY).
Recommendations
Even though we have scaled down our expectations to the pace of appreciation, it has in our view become very favourable to hedge CNY expenditure because the offshore market does not currently discount any appreciation at all.
• For corporations we recommend hedging commercial CNY expenditure. It is currently particularly favourable to hedge in the offshore CNH market, because it currently discounts the largest depreciation against the USD.
• For investors, we recommend selling USD/CNY NDFs. As we expect continued volatility in financial markets in the short run, it might be some time before the market starts to discount continued appreciation of the CNY and for this reason we prefer selling maturities exceeding six months.
Regarding hedging in CNH, it should be noted that CNH forwards will not be a perfect hedge if the commercial payment is made in CNY, due to a possible difference between the USD/CNY and the USD/CNH exchange rate. In general, the difference will be small but only if the commercial payment is made from an offshore CNH account, CNH forwards will be a perfect hedge.
• Appreciation expectations in the market have now largely been removed and in the offshore market the forward curves for USD/CNY and USD/CNH are now
upward sloping and discounting a slight depreciation of CNY over the next year.
• Hence, it now looks cheap to hedge CNY expenditures. The new offshore market in Hong Kong currently offers a particularly favourable pricing compared with the NDF offshore market and the onshore market in China.
• For investors, we recommend selling USD/CNY NDF. However, because
financial markets are likely to remain volatile in the short run, it could be some
time before the market starts to discount continued appreciation again. For this
reason, we prefer selling maturities beyond six months.
• While we expect the gradual appreciation to continue, we also expect to see
increasing two-way volatility in USD/CNY. There are signs that the People’s
Bank of China is increasingly using the space within the +/-0.5% daily trading
band, which might be widened at some stage next year.
Policy moving in a more growth-supportive direction
We expect economic policy in China to become more growth supportive in the coming months after having been focused mainly on containing inflation since early 2010. The main reason is that inflation is poised to fall sharply in coming months. CPI inflation declined from 6.1% y/y in September to 5.5% y/y in October and we expect it to plunge further to 4.4% y/y in November. The PBoC’s inflation target for 2011 as a whole is 4%. It is possible that the inflation target for 2012 could be cut slightly to 3.5% when it is announced in connection with the Central Economic Work Conference (usually held in mid-December). Our current forecasts suggest that inflation could decline below 3.5% as early as March 2012 and hence we do not expect inflation to be a major constraint on monetary policy in early 2012.
Another important target for China’s monetary policy is growth in bank loans and M2 money supply. That said, earlier this year PBoC announced that it would gradually start to target a broader credit measure (total social financing) that includes sources for credit expansion other than just bank loans. For this reason, PBoC has started to put more weight on M2 growth and less weight on bank loans in its decision making. The target for M2 growth in 2011 is 16% and we think this 16% for M2 growth will be maintained for 2012. However, PBoC is currently undershooting its 16% target for M2 growth substantially. This also suggests that PBoC should now have some room to ease monetary policy.
Recent activity indicators for economic activity (mainly manufacturing PMIs) have disappointed and suggest increasing downside risk to our growth forecast. According to our calculations, GDP growth was 6-7% q/q AR in both Q2 and Q3. This is below the 9% GDP growth that we estimate is China’s current potential growth. As can be seen in the chart on page 1, our current forecast assumes that GDP growth will improve in the current quarter. However, the weakness evident in both of China’s manufacturing PMIs suggests that growth will be weaker than we currently expect. Manufacturing PMIs in the 47-49 range indicate that that GDP growth will remain subdued in the 6-7% q/q AR range in Q4 11. Hence, we will probably have to lower our GDP forecasts for Q4 11 and Q1 12.
Based on this development, we expect economic policy in China to move in a more growth-supportive direction in the coming months. Credit growth will gradually be allowed to pick up after having been below trend in recent months. To support this development, PBoC has already cut the reserve requirement ratio (RRR) for commercial banks by 50bp. We expect the RRR to be cut twice, by 50bp in Q1 12 and 50bp in Q2 12. At this stage, we do not expect PBoC to cut its leading deposit and lending rates. It is possible that fiscal policy will also be eased slightly (construction of social housing the main tool) but, at this stage, we are unlikely to see a significant fiscal stimulus similar to late 2008 in the wake of the collapse of Lehman Brothers.
Appreciation pace poised to slow
A slower appreciation of CNY is likely to be part of a more growth-supportive approach to monetary policy. However, inflation appears to be more important than economic activity for the pace of appreciation. As seen in the top chart, in recent years there has been a close relationship between inflation and the pace of appreciation in the sense that the pace of appreciation tends to increase when inflation increases. Hence, our expectations of markedly lower inflation also suggest the pace of appreciation should ease.
Currently our model for the pace of appreciation of CNY against USD suggests that appreciation should slow to around 3% annually, from more than 5% over the past year. Besides current inflation, the pace of appreciation in our model is explained by past changes in the effective exchange rate. It appears that if the effective exchange rate appreciates significantly, then the pace of appreciation against the USD tends to slow in the following months. This suggests that China to some degree targets the effective exchange rate. In other words, if for example other Asian countries depreciate against the USD (and the effective CNY exchange rate appreciates), then China will tend to slow the appreciation of the CNY against the USD in the following months.
Appreciation expectations have been removed in the market
In the market, appreciation expectations have largely been removed in recent months. For the first time since March 2009, the 12-month USD/CNY on-deliverable forward (NDF) has since late September been trading slightly above the spot USD/CNY exchange rate. Both offshore market forward curves are now upward sloping and discount a slight depreciation of the CNY against the USD (see bottom chart). The NDF market now discounts a 0.8% depreciation over the next year while the offshore market in Hong Kong discounts a 1.3% depreciation. The onshore market in mainland China discounts a small 0.2% depreciation against the USD.
With the market no longer expecting the CNY to appreciate, it is, in our view, discounting a relatively hard landing of the Chinese economy similar to the one China experienced in the wake of the global meltdown in late 2008. China’s response in 2008 was to stop the gradual appreciation against the USD and ‘re-peg’ to the USD until spring 2010. As can be seen in the chart above, our model for the pace of appreciation actually suggests that China should depreciate the CNY at that stage. However, the Chinese leadership is aware
of the significant political and economic implications of a depreciation of the CNY under those circumstances. First, it could infuriate the US in particular and risk a trade war, because for the US there is a big difference between China not appreciating enough and actually starting to depreciate its currency. Second, just as in the wake of the Asian crisis in 1997, the Chinese leadership also judged that a depreciation of its currency would have few benefits for the economy, as it would only destabilise financial markets further and prove counterproductive for the Chinese economy. So, if China’s growth for some reason slows substantially, China’s crisis response is likely to stop the gradual appreciation temporarily, as in 2008.
With the market no longer expecting any appreciation, it does, in our view, already discount a very negative macroeconomic scenario similar to that in 2008. However, although the economic indicators have disappointed recently, they still suggest the Chinese economy is far from a situation as severe as after the financial meltdown in late 2008. After the slowdown in 2008, inflation bottomed at -1.9% y/y in July 2008. For comparison, inflation is currently above 4% y/y, albeit we suspect it could decline below 3% y/y in mid-2012. From late 2007 until November 2008, the effective CNY exchange rate appreciated by a notable 18%. So far, the effective CNY exchange rate has only appreciated by about 3% since the beginning of 2011. Finally, China’s two manufacturing PMIs plunged to the 39-41 range in the wake of the financial meltdown in 2008 whereas they are currently in the 47-49 range. The bottom line is that economic data suggests that there still is a substantial buffer before China will consider abolishing its gradual appreciation policy.
Trading band could be widened and two-way volatility increase
In a notable development in the FX markets, there are signs that PBoC is increasingly using the space it has within the daily trading band and allowing more two-way volatility in the USD/CNY exchange rate. In China the daily changes in the USD/CNY exchange rate have to be kept within the +/-0.5% daily trading band. The daily trading band is fixed daily relative the reference exchange rate fixed by PBoC every morning before trading starts. As can be seen in the chart, the reference exchange rate has, until recently, been fixed as the previous day’s close and, in general, PBoC has not really used the space it has within the daily trading band. However, this appears to have changed. In recent weeks, spot USD/CNY has been trading very close to the upper ceiling. This suggests there has been domestic selling pressure on CNY and, according to press reports, we are currently in the extraordinary situation where PBoC has been selling USD to keep USD/CNY within the trading band. This suggests that China’s accumulation of FX reserves is easing fast. As seen in the top chart, this was already evident in Q3 and we would not be surprised if China’s FX reserves turn out to have declined in Q4. The decline in FX reserves is due to a reversal of the ‘hot money’ inflows that have to a large degree been driven by appreciation expectations. However, we expect appreciation expectations to return to the market and hence the reversal of “hot money” inflows should prove temporary, although the appreciation pressure could slow substantially in the short run, given the reversal of ‘hot money inflows’ and the selling pressure on CNY.
We also regard PBoC’s recent selling of USD and keeping the reference rate substantially below the previous day’s close as a commitment from PBoC to avoid of depreciation of the CNY. However, it also suggests that PBoC is increasingly willing to use the space it has within the daily trading band. Although we expect the CNY to continue to appreciate, we should probably also get used to more two-way volatility in the exchange rate. This development reflects China’s gradual move towards a floating exchange rate. In our view, the Chinese government is targeting a floating and fully convertible currency by 2015. This is likely to be a gradual process and the next step is likely to be a widening of the daily trading band, which, in our view, could happen as soon as next year.
Yuan is now cheaper in the offshore market
Another notable development in the FX market in recent months is that the Chinese currency is now cheaper in the offshore market in Hong Kong (Chinese currency traded offshore in Hong Kong is called CNH). As can be seen in the chart, USD/CNH now trades above USD/CNY (the onshore exchange rate). This is the first time since the offshore market was established last year that the Chinese currency is cheaper on the offshore market.
The Chinese currency has previously been slightly more expensive in the offshore market due to strong demand for CNH-denominated assets in the offshore market (particularly CNH-denominated bonds) due to the appreciation in the market. However, as appreciation expectations in the market have gradually disappeared in recent months, there has also been a sell-off in CNH-denominated assets and this has weakened CNH. As can be seen in the second chart, the premium between the offshore USD/CNH exchange rate and the onshore USD/CNH is closely correlated to major changes in appreciation expectations in the sense that when there are significant appreciation expectations in the market the Chinese currency will tend to be more expensive on the offshore market and reverse if there are depreciation expectations in the market. Importantly, the premiums between the offshore and onshore exchange rates are likely to narrow over time due partly to ‘arbitrage’ from foreign trade payment.
Because we expect the market to start discounting some appreciation of CNY at some stage next year, we also expect the offshore-onshore premium to reverse so that the Chinese currency will again be slightly more expensive in the offshore market (USD/CNH will trade slightly below USD/CNY).
Recommendations
Even though we have scaled down our expectations to the pace of appreciation, it has in our view become very favourable to hedge CNY expenditure because the offshore market does not currently discount any appreciation at all.
• For corporations we recommend hedging commercial CNY expenditure. It is currently particularly favourable to hedge in the offshore CNH market, because it currently discounts the largest depreciation against the USD.
• For investors, we recommend selling USD/CNY NDFs. As we expect continued volatility in financial markets in the short run, it might be some time before the market starts to discount continued appreciation of the CNY and for this reason we prefer selling maturities exceeding six months.
Regarding hedging in CNH, it should be noted that CNH forwards will not be a perfect hedge if the commercial payment is made in CNY, due to a possible difference between the USD/CNY and the USD/CNH exchange rate. In general, the difference will be small but only if the commercial payment is made from an offshore CNH account, CNH forwards will be a perfect hedge.