After rising 3% against the U.S. dollar in 2013, the onshore yuan (CNY) weakened against the greenback last week. The offshore yuan (CNH) also fell.
UBS’ Tao Wang writes that “the era of steady CNY appreciation may be drawing to a close,” and she thinks this “is likely government-guided and may signal a change in China’s exchange rate policy.”
But she doesn’t expect large depreciation either, in part because of international pressure on China and in part because Beijing is trying to accelerate the internationalization of the renminbi.
This move away from steady appreciation could however unwind hot money inflows into China. ‘Hot money’ refers to non-foreign direct investment (FDI) capital inflows.
Naturally, the first concern would be the impact on foreign exchange inflows and on China’s liquidity and credit growth. From Wang:
So what is exactly the risk of a potential unwinding of “hot money” on China’s domestic credit boom? Contrary to what many people may think, the scale of inflows has been negatively correlated to domestic credit growth. That is, arbitrage inflows tend to increase when China is trying to slowdown domestic credit growth — when many borrowers face tougher credit constraints and higher interest rates in the shadow banking sector, and decline when the domestic economy seems to be weak or external turbulence increases uncertainty in general. In the latter case, the government usually decides and has been able to increase domestic credit growth. Therefore, the unwinding of FX inflows may not necessarily result in a sharp credit tightening in China, as the government can and usually does offset such outflows.
The risk is perhaps more on liquidity management. A sudden and large unwind of FX inflows could tighten domestic liquidity unexpectedly, and the central bank needs to react quickly and decisively to offset such contraction either through open market operations, other liquidity-injection facilities, or by cutting the still high reserve requirements and relax rules on loan-to-deposit ratios. Such a reaction may not always be seamless and without glitch. As a result, we could see volatility in the interbank market and in overall credit growth.
Another risk would be that companies and sectors that have relied on overseas funding may suffer as a result of this unwind: First, they can no longer find the funding they need, as these borrowers typically face tougher credit restrictions onshore (for example, property developers); second, they may face losses related to higher funding costs (due to the weakening of the exchange rate or a change in exchange rate expectations). Losses related to the exchange rate should be relatively limited, however. Given China’s more than $US3.8 trillion in FX reserves and the government’s desire to defend the stability of the currency, we do not expect a major depreciation even in the case of a large “hot money” unwind or outflow.
Wang thinks Beijing will now be focused on “increased flexibility of the RMB as the key objective of further exchange rate reform.”