Space for Currency and Fiscal Adjustments After Exchange Rate Appreciation

Abstract

Once the RMB exchange rate starts to rebound and gradually appreciate, the central bank will have greater room to implement consecutive interest rate cuts. In order to achieve sustainable and stable interest rate cuts, the central bank needs to take a series of measures to make the yield curve of long-term bonds steeper, to ensure long-term bond investments.

Against the backdrop of continuous interest rate cuts, on the one hand, as the interest rate gap between incremental housing loans and existing housing loans widens, consumption pressure gradually emerges, and there is room for a reduction in existing housing loan rates. On the other hand, fiscal policy is expected to become more proactive, which may first be reflected in the rapid utilization of existing fiscal space. The direction of these fiscal policies may focus more on upgrading water conservancy, electricity, computing power, and technological manufacturing industries.

At the same time, there may be considerations to increase the deficit ratio before the end of the year or introduce new quasi-fiscal tools. Based on an analysis of fiscal revenue and expenditure in the first 7 months of this year, in order to achieve the 5% growth target, we not only cannot reduce fiscal expenditures, but need to further increase the proactive nature of fiscal policy. However, due to the difficulty of rapid income recovery in the short term, the issue of adjusting the deficit ratio will become increasingly urgent and realistic.

1. Since the Third Plenum, the RMB exchange rate has been a more noticeable asset, which is related to the weakening of the US dollar and the decrease in long-term risk probability after the Third Plenum

July 22 can be seen as a watershed, the first working day after the full text of the Third Plenum was announced. From this point to September 2, the offshore RMB exchange rate appreciated by about 2.3%, from 7.27 to 7.11. The weakening of the US dollar is the main reason for the appreciation of the RMB exchange rate, decreasing by 2.5% from July 22 to the present.

(1) The appreciation of the RMB is related to the weakening of the US dollar. The weakening of the US dollar since July is mainly due to the "triple blow" that occurred in the United States during this period.

First, after the release of the second-quarter reports, US stocks, especially leading tech companies in the M7, performed below expectations. There was a contradiction between the current performance status of M7 and future capital expenditures. Therefore, some institutions had already started to reduce their holdings of M7 before the release of the second-quarter reports. This is a major reason for the decline of leading tech stocks since July, which also affected the trend of US dollar assets and the US dollar index.

Second, the US economic data in July showed worrying signs, especially the non-farm data, which accelerated the weakening of the US dollar, bringing recession trades and strong rate cut trades.

Third, the Bank of Japan (BOJ) unexpectedly raised interest rates by about 15 basis points, from 0.1% to 0.25%, which triggered a reversal of carry trades. The reversal of carry trades acted as an accelerator, further accelerating the already weak US dollar index and the declining US stock market.

(2) The appreciation of the RMB is related to changes in the internal environment.

The convening of the Third Plenum has played a significant positive role, focusing on how to further optimize existing advantages and prevent potential risks from escalating into a comprehensive crisis In response to the long-term financial challenges faced by local governments, the Third Plenary Session not only proposed to increase the overall income of local governments by integrating market elements and expanding the market size to make the "cake" bigger, but also imposed constraints on the debt expansion and redundant construction behavior of local governments. This is a fundamental reform of the incentive and restraint mechanism for local governments. In addition, the central government also expressed its intention to grant more financial power to local governments and assist in assuming more responsibilities.

We believe that in the long run, the Third Plenary Session will help reduce the likelihood of future risk escalation and alleviate the depreciation pressure on the RMB exchange rate. Since late July, the RMB exchange rate has strengthened. On the one hand, this is due to passive appreciation caused by changes in the external environment, and on the other hand, it is because our long-term solutions have effectively resisted short-term pressures. The RMB exchange rate has risen from 7.3 to 7.1, with both the central parity rate and the offshore rate remaining almost stable, indicating that the countercyclical adjustment factor has weakened in preventing further depreciation of the exchange rate, and the stability of the exchange rate depends more on its own active and passive appreciation. Currently, the RMB exchange rate remains relatively stable within the range of 7.1.

(3) There is a possibility of further appreciation of the RMB.

First, looking at the driving factors behind the depreciation of the exchange rate, this trend has not ended. The continuous weakening trend of the US dollar index indicates that the fundamental reasons supporting the depreciation of the US dollar have not disappeared. Whether it is the possible interest rate cut policy of the Federal Reserve in the future or the uncertainty in the US stock market during the third-quarter earnings season, it will further intensify the depreciation pressure on the US dollar.

We believe that the adjustment of the US stock market in the second quarter may be just a precursor. The short-term divergence caused by AI narratives in Silicon Valley and Wall Street, once exposed, will further expand. If AI applications fail to emerge as "killer" applications that significantly improve corporate performance, this contradiction will be more pronounced in the third-quarter earnings season, and market volatility will increase accordingly.

For the US dollar, this means that its depreciation trend may continue. Correspondingly, the RMB is expected to appreciate further.

Second, as the US presidential election enters a heated stage, political uncertainty poses a challenge to the US dollar index.

From September to November this year, the US presidential election will enter the most intense competition stage. The uncertainty of this political event will significantly increase, weakening market confidence. Normally, the strength of the US dollar index often reflects the stability of US politics and the continued support of allies for US assets. However, political turmoil during the election will disrupt this stable situation and put pressure on the US dollar index.

Third, the deviation between trade surplus and foreign exchange settlement and sales has led to the phenomenon of "hoarding foreign exchange among the people," becoming a potential driving force for RMB appreciation.

Since the beginning of this year, China's exports have been strong, and the trade surplus has reached a historical high. As the trade surplus continues to expand, we have not seen corresponding changes in foreign exchange reserves and the RMB exchange rate. In theory, the larger the trade surplus, the stronger the exchange rate will become. In June and July, the trade surplus reached nearly $90 billion in a single month However, unlike in the past, the trade surplus has not directly reflected in the increase of foreign exchange reserves and the significant appreciation of the RMB exchange rate. We believe this is because many enterprises, in order to pursue the appreciation of the US dollar and the higher deposit rates in the United States, have not promptly settled their foreign exchange income after earning substantial trade profits, but have chosen to keep it in overseas or domestic accounts, that is, "hoarding foreign exchange among the people".

According to Morgan Stanley, since 2022, Chinese exporters and multinational companies have accumulated over $500 billion in US dollar assets.

Once the expectation of RMB appreciation further strengthens, such "hoarded" US dollars may trigger panic selling. For example, when the RMB exchange rate reaches 7.0, if the expectation of RMB appreciation is relatively stable, enterprises may rush to convert their US dollars into RMB to avoid greater exchange losses, thereby accelerating the appreciation of the RMB.

We believe that in the future, the RMB exchange rate may not only break through 7, but may even reach the level of 6.9. Looking back, the RMB exchange rate has fluctuated around 6.9, sometimes even dropping to 6.8 or 6.7. With the relative weakness of the US dollar, the attractiveness of the RMB continues to increase. Many traders and ordinary people may start settling their US dollars, further accelerating the appreciation of the RMB.

2. From a policy perspective, after the RMB appreciates, the central bank may continue to cut interest rates

In the case of RMB appreciation, the central bank did not hide its intention to cut interest rates. At 9:00 am on July 22, the central bank announced a 10 basis point cut in open market operation rates, followed by a corresponding 10 basis point cut in the loan prime rate (LPR) to 6, and a direct 20 basis point cut in the medium-term lending facility (MLF) rate to 7, marking the second MLF operation of the month. Usually, MLF operations are conducted in the middle of the month, but the central bank's consecutive operations, even a one-time 20 basis point rate cut, undoubtedly sent a clear signal to the market.

There is not much controversy over the necessity of interest rate cuts, what is lacking is the space for interest rate cuts, and this space is determined by the RMB exchange rate. Since the beginning of this year, the RMB exchange rate has mostly faced depreciation pressure. In order to maintain the exchange rate within 7.3, the central bank has used various tools including foreign exchange reserves and countercyclical adjustment factors. Observing signs of US dollar weakness after the Third Plenum, the central bank seized the opportunity to cut interest rates. Benefiting from the external environment, while cutting interest rates, the RMB exchange rate also appreciated.

Why did the central bank seem to prefer controlling the yield curve before? We believe this is because the central bank does not want market expectations to surpass its policy pace, especially not wanting funds investing in long-term bonds to act ahead of time. Because acting ahead of time could lower long-term interest rates, which could shift the momentum of RMB appreciation to depreciation pressure.

We believe that the main determinant of the exchange rate is interest rate differentials. Among short-term and long-term interest rate differentials, the impact of long-term interest rate differentials on the exchange rate trend is greater. The central bank is preparing to cut interest rates, but long-term bond investors have acted in advance, lowering the yield of long-term bonds, which may cause the spread between domestic and foreign interest rates to widen, increase depreciation pressure on the exchange rate, reduce the possibility of the central bank cutting interest rates, as the exchange rate may depreciate as a result Before considering further interest rate cuts, the central bank has adopted various strategies to suppress the rapid decline of long-term interest rates:

（ 1 ）Verbal Intervention

The central bank has repeatedly reminded market participants through statements in financial newspapers such as the Financial Times that long-term interest rates should not decline too quickly in order to maintain the steepness of the yield curve. The central bank's verbal interventions usually emphasize the risks and volatility that high leverage may bring, especially to small financial institutions such as regional banks.

Taking Silicon Valley Bank as an example, it encountered difficulties during the Federal Reserve's interest rate hiking cycle. Trend banks also face risks during interest rate cutting cycles, especially when their asset allocations are too concentrated and extreme. Once interest rates rebound, the risks for these banks will quickly rise as their asset side lacks diversification, making risk mitigation ineffective.

（ 2 ）Direct Supervision

The Securities Association has taken direct regulatory measures on certain regional banks, especially 4 rural commercial banks in Jiangsu.

（ 3 ）Distortion Operations

Although the People's Bank of China regulations stipulate that the central bank cannot buy or sell government bonds in the primary market, it is allowed to operate in the secondary market. Around 2000, buying and selling government bonds was a common monetary policy tool for the central bank. Since then, with the enrichment of open market operation tools, the central bank rarely engages in such operations.

Recently, the central bank has taken new measures to reactivate government bond trading in the secondary market. Specifically, the central bank has added a section called "Announcement of Government Bond Trading in Open Market Operations" in its open market operation business. Its establishment indicates that the central bank plans to implement government bond trading operations in open market operations. In the new section, the central bank announced its first government bond trading operation. Over the past month, the central bank has cooperated with primary dealers to buy short-term government bonds and sell long-term government bonds, with a net purchase amount of 100 billion RMB.

By opening a new section and conducting actual transactions, the central bank shows that it is not just relying on verbal interventions but is influencing the market through concrete actions. This dispels doubts in the market about its limited operational space. Although the central bank sold long-term government bonds, it also bought short-term government bonds, ultimately achieving a net purchase. This indicates that the central bank does not intend to tighten liquidity or raise interest rates but aims to control the speed of decline in long-term interest rates. By buying short-term government bonds and selling long-term government bonds, the central bank has conducted so-called "distortion operations" in order to make the yield curve steeper. This operation aims to maintain the shape of the yield curve and prevent it from becoming too flat.

In a recent financial operation, there was an episode involving the maturity and rollover of special government bonds worth 400 billion RMB. Rollover is a routine operation where the Ministry of Finance issues new 400 billion RMB government bonds, and the central bank selects a large bank in the secondary market for targeted operations. The process of targeted rollover involves the large bank accepting the government bonds in the morning and the central bank repurchasing them in the afternoon. This is a standard procedure, but some market participants may have overlooked the maturity of government bonds and misinterpreted it as quantitative easing (QE). In reality, this is just a routine rollover of maturing government bonds and does not have a direct impact on the market The central bank has taken various measures to adjust the interest rate curve. Its ultimate goal is very clear, that is, to achieve interest rate cuts. The central bank does not want long-term interest rates to fall too quickly, as this may lead to RMB depreciation, resulting in no room for short-term interest rates to fall. Therefore, the central bank needs to maintain the shape of the interest rate curve first. Whether through distortion operations, verbal interventions, or direct supervision, the central bank's purpose is very clear, that is, to create conditions for interest rate cuts.

3. Other Changes that may occur after the Central Bank cuts interest rates

（ 1 ）Firstly, it is highly probable that the LPR will continue to decline.

Before the central bank implements interest rate cuts, deposit rates have been continuously decreasing. This downward trend is closely related to the Loan Prime Rate (LPR) in the loan market. With the decrease in deposit rates, the pressure on liabilities eases, and the LPR is likely to decrease as well. Therefore, based on the reduction in deposit rates, if the central bank further cuts interest rates, the LPR is likely to continue to gradually decline.

（ 2 ）After the LPR decreases, can existing mortgage rates follow suit?

The reason why the new mortgage rates decrease faster than existing mortgage rates is that existing mortgages are an important part of banks' assets and a stable and significant source of income. During the economic transformation period, the main risk bearers or entities that need continuous external fund inflows to maintain cash flow and a healthy balance sheet are local governments.

So, who is responsible for maintaining cash flow inflows and balance sheet balance? On one hand, it is the central government, and on the other hand, it is the banks. Therefore, ensuring that banks maintain normal profitability is crucial, as banks play the role of paying intermediaries in China's economic transformation.

Therefore, to maintain the stability of banks' cash flow and the sustainability of interest rate spreads, the speed of decrease in existing loan rates will be slower. As the net interest margin of banks has already dropped to below 1.5%, there is very limited room to further reduce existing loan rates.

However, with the decrease in LPR and new loan rates, it is a reasonable strategy to timely and moderately reduce existing loan rates. If existing loan rates remain unchanged, it may lead to a series of problems.

The first problem is that due to the significant difference between old and new mortgage rates, many borrowers choose to repay their loans early.

The phenomenon of early repayment intensified again in the second quarter of this year after the mortgage rates were lowered again 20. Currently, the gap between existing mortgage rates and new mortgage rates in some regions may be as high as 100 basis points or higher 21. In some first and second-tier cities, new mortgage rates have dropped to around 3%, for example, the first home loan rate in Guangzhou is around 3%, with some banks offering rates as low as 2.89% 22, slightly higher in Beijing, at around 3.4%, and in Shanghai it may be 3.4%.

However, the speed of decrease in existing mortgage rates is relatively slow. After the first home loan rate was lowered in 2023, the weighted average interest rate of the existing 22 trillion mortgage loans still stands at 4.27%, considering the remaining second home mortgage loans, the weighted average interest rate of existing mortgage loans will be even higher 24. Taking Beijing as an example, for first-time home buyers, after experiencing the decrease in existing mortgage rates in 2023, the existing mortgage rate is 100 basis points higher than the current new mortgage rate If it is a multiple-property buyer, the interest rate spread will be even greater.

The second issue is its impact on consumption. Post-90s buyers of their first property and post-80s buyers replacing their second property are key groups driving consumption upgrades. However, they often need large loans and high leverage to achieve property purchases. The trend of consumption upgrades among the middle class in first-tier cities is shifting towards downgrading, with one of the main reasons being the pressure of mortgage loans.

Looking at this year's consumption data, the total retail sales of social consumer goods (social retail) in first-tier cities have been negative since the beginning of the year, while the national growth mainly relies on positive growth in second, third, and fourth-tier cities. Looking at sales data from above-quota enterprises, consumption upgrades used to be the main trend, but the data for July and June mostly showed negative growth. The national growth mainly relies on below-quota enterprises, which more represent consumption downgrades and mass consumption.

The relatively high mortgage interest rate spread is also one of the reasons for the weak consumption in first-tier cities. Faced with a high interest rate spread, residents may be more willing to repay their loans early rather than consume. Recently, with the decline in consumption data, public attention and pressure on this issue are increasing. This pressure may prompt policy adjustments to ease the burden on consumers and stimulate consumption.

For banks, they face performance assessment pressure and are concerned about customers repaying loans early. For residents, in the current situation where deposit interest rates are only 1% to 2%, finding financial products with a yield exceeding 4% has become very difficult, which actually enhances the motivation for residents to repay loans early. In order to retain customers, banks may cooperate with loan applicants to help them with loan replacements.

If a comprehensive interest rate adjustment can be achieved this time, for those who purchased houses during the high interest rate and high house price period from 2019 to 2021, their monthly disposable income may increase. Taking a 30-year loan of 1 million yuan as an example, if the existing house loan interest rate can be reduced by 100 basis points, under the equal principal and interest mode, the monthly repayment amount may decrease by 500-600 yuan, thereby improving their financial situation to some extent.

Directly reducing the interest rate on existing house loans or implementing a policy of switching to mortgages is a very direct and effective strategy. We believe that compared to policies that encourage consumption through trade-ins or other more verbally encouraged means, this policy sends a strong positive signal, especially when facing seemingly unfavorable economic data. Enhancing the actual disposable income of residents, especially the middle class in first and second-tier cities, is of great significance for stimulating consumption potential and stabilizing economic growth.

Although there may be certain losses for banks, considering that the central bank will cut interest rates later and not ruling out the central bank using other means to ease the cost of bank liabilities, moderately lowering the interest rate on existing house loans is more acceptable in this situation.

4. Fiscal Policy Will Be More Active Under Monetary Easing

In the context of monetary easing, fiscal policy will also become more active. In the past, we have observed a certain asynchrony between monetary policy and fiscal policy, which may be due to fund shortages and the pressure of exchange rates not being able to bear further depreciation However, when there is no pressure for currency depreciation, interest rate cuts and monetary easing policies can be implemented. The central bank can increase market liquidity by purchasing bonds, while fiscal policy can accelerate bond issuance and improve policy execution efficiency. This synergy helps promote economic growth and stabilize financial markets.

What are the directions for proactive fiscal policy?

(1) Accelerate the use of committed funds, especially in the medium and long-term national bonds, such as the clear use of the last special national bonds during the appreciation of the RMB exchange rate.

On the day after the full text of the decisions of the Third Plenary Session of the 21st was released, the central bank reduced the open market operation rate by 10 basis points, while the Ministry of Finance announced that funds for equipment upgrades and trade-ins would be provided by the central finance from 1 trillion super long-term special national bonds, rather than borne by local finances. This will help accelerate the subsidy distribution for the trade-in of new energy vehicles. In August, retail sales of automobiles began to rebound, showing that fiscal and monetary easing policies have a short-term stimulating effect on the economy. It is expected that under the background of exchange rate appreciation, monetary easing, and proactive fiscal policy driving, the remaining funds will also be expedited to support further economic growth.

(2) Focus more fiscal funds on the upgrading of the manufacturing industry, new infrastructure (water conservancy, electricity, computing power), and other areas.

Currently, we believe that the government is less likely to invest actively fiscal policy funds in sectors such as real estate and infrastructure construction that have been relied on in the past, but is more inclined to support the manufacturing industry and consumer market that can improve production efficiency. For example, the government's "trade-in for new" policy mainly targets smart home appliances and new energy vehicles, which not only promotes equipment upgrades but also aligns with the trend of improving production efficiency, reducing carbon emissions, and sustainable development. It is expected that future policies will be more related to the upgrading of the manufacturing industry, technological progress, and improving production efficiency.

In the key focus areas of central finance, equipment upgrades and key infrastructure construction are two core areas. Especially in the water conservancy sector, investment in inland waterway transportation and canals has significantly increased in recent years, with provinces investing in canal excavation. Inland waterway transportation costs are much lower than land transportation, making it more economical for transportation businesses with low time sensitivity. In addition, the combination of inland waterway transportation with the opening of domestic ports connects inland waterway transportation to the global maritime network, even assisting in the development of canals in other countries, which helps shorten shipping distances to key export destinations such as China, Europe, and the Middle East, improving transportation efficiency.

Investment in power infrastructure is also accelerating. China's electricity generation is already more than twice that of the United States, demonstrating China's leading position in electricity production. With the development of new energy vehicles and AI computing power infrastructure, electricity has become a critical resource. In the 21st century, the abundance and cost-effectiveness of electricity may become key factors in the new technological revolution. To maintain this advantage, China will continue to strengthen power infrastructure construction, especially ultra-high voltage transmission and energy storage systems. Energy storage technology is crucial not only in the field of new energy but also plays a role in power generation and consumption. China's leading position in this field indicates the need for further investment in grid transformation, smart grids, virtual power plants, and more to lead the technological revolution In terms of data computing power, China still has a lot of room for improvement. We believe that the central bank and finance ministry may prioritize supporting the infrastructure construction from chip manufacturing to computing power centers. At the same time, the central finance will no longer rely on traditional infrastructure and real estate industries, but will improve the quality and competitiveness of Chinese manufactured goods by enhancing production efficiency and optimizing the scale and network effects of China's manufacturing industry. There is a high possibility of adjusting the deficit rate or the central bank cooperating to strengthen quasi-fiscal tools to fill the fiscal deficit gap.

From January to July this year, China's fiscal revenue and expenditure situation showed a significant imbalance. The national general public budget revenue decreased by 2.6% year-on-year, while the initial budget growth was 3.3%. Among them, central fiscal revenue decreased by 6.4% from January to July, while local fiscal revenue slightly increased by 0.6%. Non-tax revenue increased by 12%, while tax revenue decreased by 5.4%.

The government fund revenue from January to July was not optimistic, showing a double-digit decline, mainly due to the decline in land transfer revenue. At the same time, public budget expenditures increased by 2.5% year-on-year, reflecting the severe situation of the current fiscal deficit.

The deficit rate for this year was initially set at 3%, providing room for adjusting the deficit rate. Last year, the deficit rate was eventually raised at the end of October during the National People's Congress Standing Committee, issuing an additional 1 trillion yuan in national bonds, resulting in a final deficit rate of 3.8% last year. The fiscal pressure continues this year, and the possibility of adjusting the deficit rate is reserved by the initial 3% deficit rate. If the additional 1 trillion long-term national bonds cannot cover the increased fiscal gap, then adjusting the deficit rate will become necessary. Considering a similar adjustment was made last year, another adjustment this year does not seem to be an unacceptable measure. Therefore, whether the issue will be discussed at the next National People's Congress Standing Committee meeting will be a key focus.

Normally, the National People's Congress Standing Committee meets in late August, but this time the meeting is scheduled for September 10th to 13th. Although the official reason for the delay of the meeting has not been explicitly mentioned, compared to past practices, this delay may indicate topics that need further discussion.

In addition to directly increasing the fiscal deficit to fill the fiscal gap, quasi-fiscal tools may also be an option. Through methods such as PSL, policy bank efforts, etc., the central bank can provide financial support for fiscal projects to fill the funding gap caused by the decline in land transfer revenue.

Considering the August PMI was only 49.1, lower than expected, other economic indicators may generally be unfavorable, and the specific situation of these data will have a significant impact on determining the deficit rate, as well as the adjustment space for fiscal expenditures. The current limited space for fiscal expenditure compression, if there is a need to implement an active fiscal policy, raising the deficit rate or intensifying quasi-fiscal tools may be one of the fiscal choices.

6. Conclusion

In summary, when the RMB exchange rate continues to be under pressure, it may be difficult to see significant positive effects at the policy level in the short term. Against the backdrop of constrained monetary easing and difficulties in advancing fiscal policies, the implementation of many plans and projects will face challenges However, once the RMB exchange rate starts to rebound and gradually appreciate, the central bank will have greater room to implement consecutive interest rate cuts. We believe that in order to achieve sustainable and stable interest rate cuts, the central bank needs to take a series of measures to steepen the yield curve of long-term bonds, to ensure that long-term bond investments, especially those with speculative funds, do not become excessively inflated, thus providing a solid foundation for continuous interest rate cuts.

Against the backdrop of continuous interest rate cuts, on the one hand, as the interest rate gap between incremental housing loans and existing housing loans widens, consumption pressure is gradually showing, and there is room for a reduction in existing housing loan rates. On the other hand, fiscal policy is also expected to become more proactive, which may first be reflected in the quick utilization of existing fiscal space. We believe that the direction of these fiscal policies may focus more on the upgrading of water resources, electricity, computing power, and technological manufacturing industries. At the same time, there may be considerations to increase the deficit rate before the end of the year or introduce new quasi-fiscal tools. Based on an analysis of the fiscal revenue and expenditure situation in the first 7 months of this year, in order to achieve the 5% growth target, we not only cannot reduce fiscal expenditures, but need to further increase the proactive nature of fiscal policy. However, due to the difficulty of rapid income recovery in the short term, the issue of adjusting the deficit rate will become increasingly urgent and realistic