RMB Exchange Rate Stable with Foundation and Conditions

Striking a balance between internal and external equilibrium is one of the primary objectives of China's monetary policy. The Central Economic Work Conference for the years 2022 and 2023 successively called for "maintaining the basic stability of the RMB exchange rate at a reasonable and balanced level" for two consecutive years, marking the second time since the "8·11 exchange reform" in 2015 (the first time was in 2016 and 2017). The Central Financial Work Conference held in 2023 further listed "strengthening foreign exchange market management and maintaining the basic stability of the RMB exchange rate at a reasonable and balanced level" as a medium-term priority task for financial work in the current and future periods.

At the current stage, the factors affecting the RMB exchange rate are intertwined with both bullish and bearish elements.

Looking at this year's situation, the main factors influencing the trend of the RMB exchange rate are the domestic economic recovery, overseas monetary tightening, and the central bank's exchange rate regulation. The strength or weakness of the RMB will depend on whether the positive effects of domestic economic recovery can offset the negative impacts of the Federal Reserve's tightening policies and the strong US dollar.

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Entering 2024, on one hand, the improvement of the domestic economic fundamentals strengthens the support for the RMB exchange rate. The economic growth in the first quarter exceeded expectations, with external demand warming up, driving rapid growth in industrial production and manufacturing investment. The improvement in residents' income and employment conditions has driven the continued recovery of final consumption demand, further accumulating positive factors for the economic rebound. On the other hand, the withdrawal of expectations for the Federal Reserve's easing has a bearish impact on the RMB exchange rate. Due to the consecutive unexpected high inflation data in the United States in the first three months, the US dollar index and US Treasury yields stopped falling and rebounded, and non-US dollar currencies continued to bear pressure. Since April, the Japanese yen, South Korean won, Indian rupee, and other Asian currencies have hit new lows against the US dollar in recent years or even decades. The pressure on the RMB exchange rate also reflects the negative spillover effect of a strong US dollar, but the RMB's performance among major currencies remains relatively strong.

It is worth mentioning that, despite the yen exchange rate continuously hitting new lows in 34 years, the current situation is significantly different from the period of the Asian financial crisis. On one hand, compared to more than 20 years ago, the balance of current account payments in the Asian region has improved, exchange rate policy flexibility has increased, foreign exchange reserves have grown, and the scale and structure of external debt have become more rational, significantly improving the resilience to external shocks from the strong US dollar cycle. On the other hand, compared to more than 20 years ago, the economic and financial influence of Japan and China in the Asian region has shifted, with the RMB becoming the nominal anchor for an increasing number of Asian currencies. The RMB exchange rate maintains basic stability and plays the role of a "stabilizer" for Asian currencies.

The resilience of the foreign exchange market is the confidence behind China's stable exchange rate.

As the probability of the US economy "landing" increases, the expectation of the Federal Reserve delaying and reducing the number of interest rate cuts will continue to be a "headwind" for the RMB exchange rate in 2024. During the "8·11 exchange reform" in 2015, partly due to the divergence of monetary policies between China and the US, the positive interest rate differential narrowed, and the RMB exchange rate continued to bear pressure. From 2015 to 2017, the RMB exchange rate fell for three consecutive years, with a cumulative drop of nearly 9%. This time, the monetary policies of China and the US are again out of sync, with the negative interest rate differential expanding. In 2022 and 2023, the average annual exchange rate of the RMB fell for two consecutive years, with a cumulative drop of 9%. Currently, it appears that 2024 will be the third year for the RMB exchange rate to continue adjusting.

The People's Bank of China has emphasized on multiple occasions that the RMB exchange rate has the foundation and conditions to maintain basic stability. A strong economy leads to a strong currency. According to the deployment of the Central Economic Work Conference, consolidating and strengthening the positive momentum of economic recovery is the key to stabilizing the exchange rate. At the same time, while adhering to the principle that the exchange rate is determined by the market, continuously improving exchange rate regulation and maintaining the basic stability of the RMB exchange rate is also about buying time for economic adjustments.

It should be pointed out that, although from the price dimension, the current foreign exchange market pressure is similar to the early stages of the "8·11 exchange reform," from the quantity dimension, the foundation of the foreign exchange market is different from the past.

Firstly, before the "8·11 exchange reform," since the unification of the exchange rate in early 1994, the RMB has experienced more than 20 years of unilateral appreciation, and market entities were neither mentally nor operationally prepared for RMB devaluation. However, after the exchange reform in 2015, especially after the RMB exchange rate broke through "7" in August 2019, the RMB exchange rate has repeatedly fallen below and then returned to within "7," with two-way fluctuations becoming the norm, and the market will not pay excessive attention to the rise and fall of the exchange rate.Secondly, prior to the "8.11 FX Reform," under the long-term one-way appreciation trend, a phenomenon of domestic assets being denominated in local currency and liabilities in foreign currency emerged, accumulating a massive net external debt. At the beginning of the "8.11 FX Reform," the unexpected depreciation of the renminbi triggered market entities to concentrate on increasing overseas asset allocation and repaying external debts in a pro-cyclical operation, leading China to face a high-intensity cross-border capital flow shock of "capital outflow - reserve decline - exchange rate depreciation." However, after that wave of concentrated adjustment, by the end of 2023, the net external debt of the private sector had dropped to $541.5 billion, a significant reduction of $1.83 trillion compared to the end of June 2015 (on the eve of the "8.11 FX Reform"). The currency mismatch in the private sector has improved significantly, greatly enhancing the market entities' tolerance to renminbi depreciation. Since August 2019, the renminbi exchange rate has fluctuated around "7" multiple times, and the foreign exchange market has maintained stable operation, withstanding the test.

Thirdly, with the increase in the internationalization of the renminbi and the enhancement of the renminbi exchange rate flexibility, domestic market entities are increasingly using local currency pricing and settlement, as well as foreign exchange derivative tools to hedge and offset exchange rate risks, and their adaptability and tolerance to exchange rate fluctuations have also significantly increased. Benefiting from this, in recent years, the domestic foreign exchange market has generally shown the operational characteristics of "settling at high levels and purchasing at low levels."

The responsible person of the State Administration of Foreign Exchange has repeatedly pointed out that China's foreign exchange market operation has shown strong resilience, and market expectations and transactions have remained rational and orderly. This is a professional judgment based on data. For example, 2023 was the second year of this round of renminbi exchange rate adjustment. Looking at the situation of bank settlement and cross-border capital flows, there have indeed been some new changes compared to the previous year. Both bank settlement and bank cross-border receipts and payments on behalf of customers have shown a deficit for the first time since 2019. However, from a comparable perspective, in 2023, the bank spot and forward settlement deficit was $43.6 billion, far lower than the scale of $571.2 billion and $369.5 billion in 2015 and 2016, respectively, and also lower than the scale of $89.3 billion in 2017; the bank's cross-border receipts and payments on behalf of customers had a deficit of $68.7 billion, while in 2015-2017, they were $194 billion, $305.3 billion, and $124.5 billion, respectively. This reflects that the current degree of foreign exchange supply and demand imbalance and the intensity of capital flow impact are far less than at that time, and China's foreign exchange market has gradually moved towards increasing maturity. Equating the appreciation and depreciation of the renminbi to appreciation and depreciation pressure and expectations is a manifestation of lacking international financial knowledge and a serious misunderstanding of exchange rate marketization. Exchange rate marketization is to allow the market to play a fundamental role in the formation of exchange rates. Under normal circumstances, it should be "sell high (appreciation) and buy low (depreciation)." It is precisely the rigidity of exchange rates that accumulates one-way pressure and strengthens one-way expectations. If this situation occurs in exchange rate fluctuations, it means that the market has shown a pro-cyclical one-way herd effect, and the central bank needs to implement necessary intervention.

From the perspective of the balance of payments, the bank settlement and bank cross-border receipts and payments data are unique foreign exchange income and expenditure statistical indicators in China, while the balance of payments data are more internationally comparable. Data analysis from the balance of payments perspective can also support the aforementioned conclusions.

The market once worried that renminbi depreciation would accelerate capital outflow, but in reality, China's capital outflow pressure in 2023 was not divergent but convergent. In 2023, China's capital account deficit in the balance of payments was $248.2 billion (including net errors and omissions), a decrease of 18.7% year-on-year. Among them, the net outflow of short-term capital was $105.6 billion (also known as capital flows in the form of non-direct investment, including net errors and omissions), a decrease of 67.7%. Behind this is the normal functioning of the exchange rate decline's "rewarding in and limiting out" regulatory effect on capital flows. In reality, there are two main bodies in cross-border capital flows: domestic capital (i.e., outward investment, corresponding to the asset side of the non-reserve financial account) and foreign capital (i.e., incoming investment, corresponding to the liability side of the non-reserve financial account). In 2023, China's private capital account (i.e., non-reserve financial account) had a net outflow of $209.9 billion, a decrease of 18.4% compared to the previous year. Among them, the net outflow of private outward investment was $223.4 billion, a decrease of 6.4%; the net inflow of private incoming investment was $13.4 billion, compared to a net outflow of $18.7 billion in the previous year.

Looking at a longer period, the aforementioned conclusion also holds. From 2022 to 2023, China's capital account had an average annual deficit of $276.8 billion, a decrease of 39.3% compared to the average in 2015-2017; the average annual net outflow of short-term capital was $216.3 billion, a decrease of 54.4%. During the same period, the private capital account had an average annual deficit of $233.6 billion, 5.4% lower than the average in 2015-2017. Among them, the average annual net outflow of private outward investment was $231 billion, 48.3% lower than the average in 2015-2017, and 65.9% lower than the average in 2020-2021 (the last round of renminbi exchange rate appreciation period). This reflects that in this round of renminbi exchange rate adjustment, the expectations of domestic market entities have remained basically stable, and the previous "hiding exchange in the people" policy has played a "reservoir" role in smoothing the pro-cyclical fluctuations in capital flows. At the end of 2016, when the market was debating whether to protect the exchange rate or reserves, the net outflow of private outward investment was $675.6 billion, an increase of 1.02 times compared to the previous year, and incoming investment turned from a net outflow in the previous year to a net inflow of $259.6 billion. Obviously, at that time, the key to stabilizing the exchange rate was to stabilize the onshore market's confidence in the renminbi. In 2017, not only did the renminbi exchange rate not break "7," but it also rose by more than 6%, dealing a heavy blow to the forces shorting the renminbi and reshaping the credibility of exchange rate policy.

The sharp reduction in private net external debt has greatly constrained the actual demand for foreign exchange under financial transactions under depreciation pressure. Benefiting from this, in March 2024, there was a fluctuation in the domestic renminbi exchange rate, and the gap in domestic foreign exchange supply and demand expanded, but this was mainly due to the weakening of the market's willingness to settle, rather than an increase in the motivation to purchase foreign exchange. In addition, compared with the last two months of 2023 (when the renminbi stopped falling and rebounded), the market's willingness to settle increased, and the motivation to purchase foreign exchange weakened in the first three months of this year, and the exchange rate leverage regulatory effect of "buying low (appreciation) and selling high (depreciation)" is still functioning normally.

From the perspective of international experience, an important prerequisite for a successful currency attack is that domestic residents and enterprises panic-buy and hoard foreign exchange. Obviously, China has not seen this situation, which is an important reason why foreign forces have repeatedly failed to short the renminbi in recent years. The Chinese experience has once again shown that only when the domestic economic and financial system is healthy can the benefits of exchange rate fluctuations and capital flows be fully enjoyed. Coupled with China's experience of multiple rounds of capital inflows and outflows, renminbi appreciation and depreciation, the macro-prudential management framework has been continuously improved, and rich experience in exchange rate regulation has been accumulated. This is the confidence, capability, and condition that China has to maintain the basic stability of the renminbi exchange rate.