Recent events in China provide yet more support for our view that the renminbi (RMB) will continue to appreciate steadily—and that the country will proceed more rapidly with its reforms than most people expect.

Beijing Sees Need for RMB Strength

Many critics of China’s policymaking have called for a depreciation of the RMB to stimulate China’s export trade, or have warned that the currency will effectively devalue anyway as the US economic recovery causes the dollar to strengthen. Some devaluation of the currency has indeed taken place recently for that reason.

Our conviction that the RMB will remain stable in the short term and continue to appreciate in the medium to long term has strengthened recently, for three reasons.

First, during a recent visit to Beijing, we met senior officials who argued persuasively that there was no plan to devalue the RMB or widen its trading band with the US dollar. They pointed out that devaluation was unnecessary, given China’s continuing strong export performance compared to its regional and emerging-market peers. They also noted that the RMB’s appreciation in real effective exchange-rate terms had not undermined China’s export competitiveness.

One official stressed that if China were to devalue, other regional and emerging-market economies would come under pressure to devalue, too. He added that there were also domestic reasons for a robust currency (the need to import components to allow China’s manufacturing industry to move up the value chain and to deter capital outflows into stronger currencies) as well as the need to maintain the RMB’s strength to help internationalize the currency.

Second, at a conference in Beijing in March, Zhou Xiaochuan, Governor of the People’s Bank of China (PBC), revealed that the central bank was aiming for full convertibility of the RMB this year. We had assigned the project a two- to three-year time frame. Policymakers are targeting two near-term milestones: inclusion of the RMB in the International Monetary Fund’s Special Drawing Rights basket, and inclusion of China in global bond and equity market indices. For both, a strengthening, or at least stable, currency would be a prerequisite.

Third, earlier this month, the Financial Times published an interview with Premier Li Keqiang in which he stressed that he wanted to see no further depreciation in the currency. Indeed, he echoed the comments of one of his officials above when he said, “I don’t want to see the RMB depreciate further, because we cannot stimulate exports through depreciation without focusing on improving domestic demand. Otherwise, it will be very difficult for China to rebalance its economic structure.”

Pace of Reform Quickens, but Policy Risks Remain

The target of full RMB convertibility may seem ambitious, but the pace of reform in China is nothing if not rapid. In March, Premier Li gave approval for some regional authorities to convert bank loans into municipal bonds. While it’s not yet clear how the original debt providers will be affected in terms of the cash flows they receive, the loan-for-debt swap will to some extent free up bank balance sheets and help reduce systemic risk. The move will be an important step in the development of China’s domestic capital markets—not least because it will grow the municipal bond sector by US$300 million virtually overnight.

The risk to China’s reform targets lies in the policy imperative of managing the slowdown in the economy while keeping a floor under employment. If further stimulus becomes necessary, how likely is Beijing to choose devaluation over another cut in interest rates?

In our view, very unlikely. While China has been easing monetary policy for the last year or so, we believe it has scope to cut rates further. The PBC’s one- and seven-day repurchase rates (the rate at which the central bank lends to commercial banks) have been rising. This may seem surprising, given the volume of liquidity that’s been flowing into the system from successive monthly record trade surpluses (Display).

Domestic RMB liquidity, however, has in fact become quite tight as a result of domestic investors seeking to take advantage of the rising US dollar. The trade has consisted of transfers between domestic accounts rather than capital outflows, as we’ve seen from the sharp rise in foreign-currency deposits since last year. In light of this, policymakers would be even more reluctant to devalue the RMB, as this would result in more inflows.

Another reason that devaluation is unlikely is that China has never varied the exchange rate for reasons of domestic policy. This is because the country is a net importer of commodities, and a strong currency is to its advantage. As commodity prices continue to fall, a robust RMB will help the margins of domestic businesses expand—a vital component in helping to underpin growth.

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.

© AllianceBernstein

© AllianceBernstein

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