Many investors with exposure to the Chinese renminbi (RMB), having enjoyed a strong rally in the second quarter, are worried that policy uncertainties could hurt the currency’s short-term outlook. In our view, however, the risks are balanced in favor of further appreciation.
The recent rally took the RMB to its strongest level in three years against the US dollar and many other currencies. But the euphoria hasn’t lasted. Increasing talk about the Federal Reserve tapering its bond buying program has raised the prospect of higher US interest rates, which could make the dollar more attractive relative to the RMB. The People’s Bank of China (PBOC) has also taken steps to moderate the RMB’s recent rise.
Despite these developments, we believe that the RMB could be poised to make further gains in the short term.
Carry Trade Should Weather Fed Taper
One of the factors underpinning the RMB’s strength has been the attractiveness of its carry trade—that is, borrowing in a lower-yielding currency to invest in the RMB. In this respect, the RMB has benefited from both its relative stability and attractive yield.
The currency has moved broadly in line with the euro and British pound, for example, partly reflecting that they share the same US-dollar denominator. As the Display shows, however, the euro and pound have been more volatile than the RMB over the past decade, resulting in the RMB providing a better risk-adjusted outcome.
When adjusted for carry, or the yield investors earn when buying these currencies, the difference between the RMB and the other currencies is more pronounced (Display).
The RMB offers a yield advantage of 2.25% to 2.75% relative to the euro, pound and US dollar. Not only has this resulted in a higher relative return due to carry, but it provides a buffer in case the RMB suffers any modest depreciation in the short term.
Some investors are concerned that, as the US economic recovery continues and the Fed tapers its bond purchases, the carry trade could come under pressure. These prospects revive bad memories of the mid-2013 taper tantrum, in which US real interest rates rose sharply and triggered a strong dollar rally.
We believe that investors with RMB exposure should stay the course. The 2013 playbook is unlikely to be replayed in 2021. The Fed’s commitment to supporting fiscal policy and not acting pre-emptively against potential inflation has been well telegraphed. We can expect both US real and nominal yields to rise, but the extent and pace will likely be much less disruptive than in 2013.
Long-Term Policy Goals Lend Short-Term Support
Recent moves by China’s central bank have been perceived as another policy risk. Since the second-quarter rally, the PBOC has taken steps to contain the RMB’s rise, including a directive to financial institutions to increase their foreign-currency holdings. This limits banks’ scope to deal in foreign exchange and influence exchange rates.
But such initiatives are aimed primarily at taking the speculative heat out of the currency. China’s broader policy measures remain supportive of further RMB appreciation, in the short term as well as longer-term. For example, the opening of China’s capital markets, while a long-term strategy, is likely to be supportive for the RMB in 2021 and 2022.
Chinese bond and equity markets have benefited from foreign portfolio inflows, as investors rebalance their funds to match benchmarks that now include significant allocations to Chinese securities. In the case of the bond market, these flows will rise again in late 2021 as Chinese Government Bonds (CGBs) enter the widely followed FTSE World Government Bond Index.
Index changes aside, CGBs are likely to appeal to foreign investors because their nominal and real (inflation-adjusted) yields are so much higher than those of other large bond markets. Five-year real, or inflation-adjusted, CGB yields are 2.0% compared to –1.50% for US Treasuries and –1.70% for the German Bund.
Recent PBOC guidance indicates that real CGB yields will remain positive and attractive into 2022, adding a measure of inflation protection to the attributes helping make the RMB attractive to offshore investors.
It’s not just bond and equity markets that China is keen to open up. In late May, the PBOC and the State Administration of Foreign Exchange announced an increase in the debt limit for locally incorporated foreign banks. These changes should support foreign banks’ China operations and lead to stronger capital flows into China.
At the end of 2020, the onshore assets of the 41 foreign commercial banks in China accounted for 1.2% of the system’s total assets. There is plenty of room for growth.
FX-Rich Exporters May Bolster RMB Demand
A potential new source of short-term support for the RMB comes from China’s exporters, who have contributed strongly to the country’s economic recovery in 2020 and 2021. The amount of foreign currency (mainly US dollars) sitting in domestic deposits now exceeds US$1 trillion for the first time (Display).
This creates the potential for exporters to convert some these deposits into RMB—particularly if they see room for RMB appreciation and the opportunity to earn extra carry.
Signs Point to Resilience and Appreciation
July 1, 2021, marked the 100th anniversary of the founding of The Chinese Communist Party. Given the RMB’s importance as a symbol of national prestige and China’s strong desire to reduce its reliance on the US dollar for trading and transacting with global counterparties, we expect that the currency’s strength and stability will remain a core policy focus for the Chinese government during this period and beyond.
Indeed, stability has been one of the currency’s key characteristics for many years, particularly during periods of global market volatility, including the 2008 financial crisis, 2012 European debt crisis and 2020 COVID-19 pandemic.
With many factors pointing to the currency’s continued resilience and potential for short- and long-term appreciation, we believe investors—whether they have RMB exposure or are thinking of acquiring some—should consider taking a positive, long-term view of the opportunity.
Brad Gibson is Co-Head of Asia Pacific Fixed Income at AllianceBernstein (AB).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.