RMB under pressure again in the face of possible risk events in June

Over the past week, discussion on whether a Fed rates hike in June is possible or not continued to heat up. At the same time, the Brexit vote also kicks in the nerves of the market.Foreign exchange traders are on the alert to the two possible black swarm events likely to happen in June. To the concern of market, the RMB continues to lose its strength as the U.S. dollar rallies.

Yesterday, the central parity rate of the RMB fell sharply to hit new record low in five years. Industrial insiders worried that the resurgence of expectation of RMB depreciation may cause another panic selling in the Chinese market as what happened in this January.

Expectations for Fed rates hike heighten

Since the beginning of May, the central parity rate of RMB has fallen in choppy trading. After weakened 315 basis points on May 19, the central parity rate further reduced by 225 basis points to 6.5693(previous trading day: 6.5468) against U.S. dollar, the lowest since March 2011. In the wake of this condition, the market conjectures that RMB will soon enter a new round of depreciation.

It is widely belief that continuous weakening of RMB for days is directly linked to the heightened expectation of Fed rates hike and rally of U.S. Dollar Index.

The Fed’s April minutes issued on May 18 unexpectedly revealed the possibility of a rates hike in June, causing heated discussion in the global market. On May 23, various Fed officials reiterated on different occasions that once the U.S. economic recovery reached expectation, the Fed will increase rates in June. And the U.S. economy could withstand two to three rates hikes this year.

“Market expectation towards Fed rates hike has changed enormously, and the expectation of a rates hike in June heightened. The market’s reinterpretations of the prospect of Fed rates hike have remarkably improved the fundamentals of the U.S. dollar,” Zhong Yue, Chinese market analyst with FXTM told the China Business News.

Since the beginning of May, the U.S. Dollar Index has gained 3.5 percent against a basket of currencies, the biggest increase so far during the year. Three consecutive weeks of rally of the U.S. dollar makes an increasing number of people believe the U.S. dollar will continue to appreciate.

“Be it June or September, it is just a matter of time for a Fed rates hike. The prospect of a rates hike remains unchanged,” said Liu Dongliang, senior analyst with the assets management division of China Merchants Bank.

“Therefore, the U.S. dollar’s supremacy over other currencies resulted from the broadening interest rate spreads is just the beginning. The strong dollar is far from reaching the limit. And this is an external environment China has to face in respect of RMB exchange rate and capital flows in the long run,” Liu said.

“Once RMB is officially included in IMF’s special drawing rights (SDRs) currency basket, China’s exchange rate regime will be made more flexible,” a foreign exchange analyst with the wealth department of Citibank told the journalist. In this regard, the Citibank has adjusted its estimate on the value of RMB: 6.60 yuan per U.S. dollar within the next three months, and 6.75 yuan per dollar in the next six to twelve months.

Fix on external risks in June

In addition to U.S. rates hike, RMB likely faces other risk events in June, including Brexit.

The euro’s weight in the U.S. Dollar Index is as high as 57.6%. Once the risk of Brexit on June 23 pressures on the pound, the euro will largely be affected. This will further drive up the U.S. dollar, which is likely to increase the downward pressure on RMB.

“If above speculation turned into reality, the prices of the pound, the Gilts and other bonds would all face huge pressure. The pound could depreciate by 10 percent to 20 percent, and cause damage to investors’ confidence in the near term,” said Neil Dwane, chief strategist with Allianz Global Investors.

Referring to relationship between RMB and USD, market generally surmises the intention of the central bank through changes of daily middle rate, but in fact, the central bank has continuously stressed since 2015 that formation mechanism for the middle rate of RMB/USD exchange rate is controlled based on market supply & demand and a basket of currencies.

With the “new exchange rate reform” on August 11, 2015, the central bank proposed that the offering middle rate of RMB/USD exchange rate should take the closing exchange rate of previous day into account. After that, it declined by 3 percent for a third consecutive day. The market completed one-time adjustment on the middle rate of RMB in extreme sudden time.

China Foreign Exchange Trade System (CFETS) issued RMB exchange rate index on Dec. 11, 2015, highlighting that it will consider the strength of a basket of currencies to better stabilize the exchange rates between RMB and a basket of currencies.

In terms of these two important reforms, Xie Huaizhu, vice director of international finance research department at the PBOC Research Institute, told the journalist that “new exchange rate reform” on August 11 effectively improves the benchmark role of RMB/USD middle rate based on data, and realizes the significant reform target; RMB exchange rate index issued by the CFETS effectively raises the RMB’s flexibility, changing from stable variation trend against USD in the past.

It is worthy to notice that the central bank finally disclosed the pricing mechanism of RMB middle rate not long ago, which had always been “mysterious” in the market.

In the latest executive report of monetary policy in the first quarter of 2016 issued by the central bank on May 6, the central bank explains how to determine the middle rate of RMB/USD rate for the first time, and indicated that the mechanism based on “closing exchange rate + changes in exchange rates for a basket of currencies” preliminarily forms. When market makers offer the middle rate of RMB/USD exchange rate, they should consider the said two parts in the formation mechanism.

On the whole, the RMB has experienced three major events since the beginning of this year: “great appreciation in Euro, Yen and Canadian dollar + basic factors of China and the U.S. process in the same pace almost without contradiction”, therefore, it can realize a condition of “both USD index and CFETS index decline + stable operation of RMB/USD middle rate”.

It may be different from the appreciation logic in which the USD will step in the future. Zhang Yu in charge of overseas research at Minsheng Securities told the journalist that only three situations can worsen the basic factors of China and the U.S. step on a way to contradiction: increasing U.S. dollar + increasing CFETS + flat middle rate, increasing U.S. dollar + flat CFETS + decreasing middle rate, and increasing U.S. dollar + slight increase in CFETS + slight decline in middle rate. “Based on current situation, the third one is more likely to happen, CFETS and the middle rate work together to hedge the appreciation of U.S. dollar.”

In terms of development orientation for China’s foreign exchange market, authoritative insider of People’s Daily mentioned in the interview on May 9, “It aims to improve the autonomy of monetary policies, make the mechanism play a role of automatically adjusting the international balance, and maintain the basic stabilization for exchange rate. Meanwhile, the operational mechanism of exchange rate should gradually form focusing on market supply & demand, tow-way fluctuation and flexibility.”

To this respect, Liu Dongliang analyzed that China now has determined to keep a L-shape trend for the economy, and the RMB must face a long-term internal environment of slowing-down economic growth and low interest rate. “It is not necessary to worry, if the RMB depreciates for a while in the future, as it is a result jointly worked out by internal & external environments and strategic factors. We should calm down when facing it.”

(APD/XH FINANCE)