$1 trillion funds may flow back to China? RMB appreciation warning sounded

Renowned for proposing the "Dollar Smile Theory," Stephen Jen believes that as the Federal Reserve cuts interest rates, Chinese companies may sell $1 trillion worth of US dollar assets, potentially causing the Renminbi to appreciate by 10%.

Jen, who previously served as the global currency research head at Morgan Stanley, now serves as the CEO of the UK hedge fund Eurizon SLJ Capital. When discussing the impact of the inflow of Chinese assets, he stated, "Think of an avalanche scenario. The Renminbi will appreciate, and this is likely to be allowed—a 5% to 10% appreciation will not be too large, and China can also accept it."

Jen's theory is as follows: Since the outbreak of the COVID-19 pandemic, Chinese enterprises may have accumulated over $2 trillion in overseas investments because the returns on these assets are higher than those denominated in Renminbi. However, as the Federal Reserve cuts interest rates, the attractiveness of US dollar assets will diminish, potentially stimulating the inflow of $1 trillion in "conservative" funds back to the country, as the interest rate differential between China and the US narrows.

Jen predicts that if US inflation continues to cool down, the extent of the Federal Reserve's interest rate cuts will exceed market expectations. This, coupled with the overvalued US dollar, as well as the prospect of the US facing twin deficits and a soft landing, makes him more convinced that the US dollar will decline.

The ultimate result is that the Renminbi's exchange rate against the US dollar is likely to rise. On Monday, the onshore Renminbi exchange rate against the US dollar was around 7.12, having dropped to nearly 7.28 in July.

Jen mentioned in an interview last week that if the People's Bank of China does not intervene to absorb US dollar liquidity, the Renminbi's rebound could be even greater.

Federal Reserve Chairman Powell stated last Friday at the Jackson Hole Economic Symposium that the time has come for the Federal Reserve to lower its policy interest rate, making the case for the Renminbi's appreciation now seem more compelling.

However, the Renminbi is unlikely to appreciate significantly immediately after the Federal Reserve's first rate cut. Jen pointed out that this scenario may occur when the US dollar accelerates its decline in a so-called soft landing situation, or when US inflation slows down without triggering an economic recession.

His views align with those of Guan Tao, the Chief Economist of Bank of China International, who recently stated that due to international market fluctuations, there is a possibility of a rapid and substantial appreciation of the Renminbi as a result of exporters' foreign exchange settlement and unwinding of carry trades.

Guan Tao mentioned that Chinese enterprises hold significant foreign exchange positions, and while the willingness of exporters to settle has slightly eased, the fundamental expectation of Renminbi depreciation has not been fundamentally reversed; once unidirectional expectations fluctuate, it may trigger a significant and rapid appreciation trend He explained that if a situation similar to the collapse of the yen carry trade occurs, the renminbi could soar. The impact of unwinding carry trades is significant, affecting various aspects such as stocks, credit, and emerging currencies. The collapse of carry trades funded by renminbi could trigger a new round of panic, especially in Asian markets.

Some others estimate that Chinese companies' US dollar foreign exchange reserves are slightly less than what Jen estimated.

Macquarie Group Ltd. estimates that since 2022, US dollar assets held by Chinese exporters and multinational companies have exceeded $500 billion. The estimates from Australia and New Zealand Banking Group are $430 billion.

Jen stated that regardless, "the pressure for a renminbi rebound will exist"