At the time of writing, the RMB has appreciated by 6.1% from the end of last year, and by 5.2% since my call for RMB to strengthen on 22 May 2017. Meanwhile, the RMB’s trade-weighted exchange rate, or the CFETS index, has risen by more than 3% in the six weeks since late July.

This rapid appreciation of the RMB may have caught the PBoC off guard. In order to keep the currency from overshooting due to herd instinct and keep overall macro stability in the Chinese system, the PBoC has acted to curb the RMB’s appreciation pressure. It announced on 8 September to remove the 20% reserve requirement for onshore financial institutions to set aside when buying FX forwards for clients (the rule was introduced on 15 October 2015 to reduce capital outflows), and to scrap the reserve requirement for offshore banks’ interbank renminbi deposits held onshore (this rule was introduced on 15 July 2016 to deter offshore short-selling of renminbi using onshore funding).

Some players have jumped to the conclusion that these moves would reverse the RMB’s strength because they reduce the cost of hedging (and short-selling) the renminbi. This view makes no sense, as the PBoC’s moves do not necessarily change renminbi sentiment, just as they were ineffective in arresting the renminbi’s depreciation pressure when they were introduced (Chart 1). The renminbi’s recent strength was a result of:

1. USD weakness

2. Improvement in sentiment towards China as a result of fading capital outflows, disappearance of economic hard-landing fears and MSCI inclusion of some A-shares in its global EM indices

3. FX sales by onshore companies (Chart 2) on the back of fading fear of one-way RMB depreciation. From a policy perspective, the strength is a result of the PBoC’s FX policy shift since July to keep the renminbi’s trade-weighted exchange rate (approximated by the CFETS index) stable by using the CNY-USD cross-rate as an adjustment factor (i.e. when the CFETS index weakens, the PBoC lets the renminbi appreciate against the USD to pull up the trade-weighted exchange rate so that the CFETS index remains stable. Conversely, when the CFETS index strengthens, the PBoC lets the renminbi fall against the USD to push down the trade-weighted exchange rate so that the CFETS index remains stable).

Due to the FX policy shift, the decline of the CFETS index in 1H 2017 has prompted the PBoC to let the renminbi rise against the USD sharply since July to reverse the weakness of the CFETS index, delivering more than 3% gains in recent weeks (Chart 3). There is also a near-term political factor for consideration. To prepare for the visit by US President Trump in November, Beijing may be allowing the renminbi to rise against the USD in order to soothe the tension that Trump may bring to the negotiation table over Sino-US trade.

What happens next will depend on the USD’s direction and the PBoC’s FX policy. If the dollar weakens further, ceteris paribus, the CFETS index would weaken again. And if the PBoC keeps its FX policy by targeting a stable CFETS index, it would let the renminbi rise further against the USD. At this stage, the market is expecting the PBoC to hold the CFETS index stable at the current level of around 95, implying more renminbi strength going forward.

However, if the renminbi strengthens too fast too much, the PBoC will likely intervene in the FX market to slow down its appreciation. So far there has been no evidence of direct FX intervention. But the PBoC’s moves on 8 September to reverse the reserve requirements for financial institutions to buy FX may help pare the renminbi’s strength indirectly in the short-term by reducing the cost of buying FX. However, they do not change the underlying currency sentiment. The moves also reflect the Chinese authorities’ improved confidence in the renminbi’s outlook and their effort to continue market liberalisation whenever the environment allows.

Last but not least, the market estimates that onshore companies are sitting on some 500 billion of USD as a result of their FX hoarding between 2015 and 2016 due to the expectation of large renminbi depreciation/devaluation. Now that the fears have gone and they are starting to unwind their FX positions. This force will sustain the renminbi’s strength for a good while longer, especially if renminbi sentiment continues to improve. What Next for the Chinese Yuan?

At the time of writing, the RMB has appreciated by 6.
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