The Renminbi strengthens, Hong Kong stocks shine, is this just the beginning?

Key Points

Since July 25th, the RMB to USD exchange rate has been strengthening, with a cumulative appreciation of 2.7%. The offshore RMB exchange rate is approaching a 15-month high of 7.08. Starting from August 29th, the closing price of the RMB to USD exchange rate has been significantly stronger than the midpoint price, marking the first time since July last year (Charts 1 and 2). Along with the RMB's strength, the performance of the Hong Kong stock market has been impressive. Recently, Chinese concept stocks and A-share indices have rebounded, indicating a potential warming trend in global market sentiment towards RMB assets. This article briefly analyzes the underlying driving factors behind the recent RMB strength and discusses the main "observation points" at the macro level, RMB exchange rate, and RMB asset trends.

The recent strength of the RMB is the result of multiple factors interacting with each other, reflecting some marginal corrections to the previously pessimistic market pricing:

1. The recent increase in expectations of a Fed rate cut, combined with the rapid strengthening of the Japanese yen, has led to a partial reversal of the yen-denominated carry trade, particularly benefiting Asian currencies, especially low-yield currencies. As the U.S. economic data weakens, the Jackson Hole meeting in late August further signaled a clear message of the Fed's imminent rate cut in September and the increasing urgency to stabilize growth and employment (see "Fed Chairman's Annual Meeting Speech: Urgency for Rate Cut Overflowing with Words," August 24, 2024). On the other hand, the unexpected rate hike by the Bank of Japan on July 31st, combined with the weakening U.S. growth expectations leading to a rapid narrowing of the U.S.-Japan interest rate differential, significantly boosted the yen, triggering a partial reversal of carry trades (Chart 3). In addition to the yen, due to the widening U.S.-China interest rate differential this year, the outstanding positions of RMB carry trades have also increased. As of August 26th, the total outstanding positions of RMB futures on the Singapore and Hong Kong exchanges amounted to approximately $23 billion (about 164 billion yuan). With the partial reversal of yen carry trades, the RMB exchange rate, also a low-yield currency, has strengthened, with a cumulative appreciation of 2.2% against the USD since July 31st, while the CFETS index against a basket of currencies has fallen by 1.4%.

2. Since Thursday (August 29th), the RMB has shown a relatively independent and strong trend against other Asian currencies, which may partly reflect anticipation of marginal easing in U.S.-China relations. Over the past two trading days, the RMB to JPY exchange rate has significantly strengthened, with an accumulated increase of about 1.2%. In the absence of a weakening USD, the RMB has appreciated against the USD, and the CFETS index against a basket of currencies has also risen against the trend. The relatively strong and independent trend of the RMB against other Asian currencies may be partly boosted by expectations of improved U.S.-China relations. From August 27th to 29th, U.S. National Security Advisor Jake Sullivan visited China, and both sides held a new round of strategic communication. Following the meeting, the White House indicated that the U.S. and Chinese presidents may have a phone call in the coming weeks, and did not rule out the possibility of a meeting at the G20 and APEC summits. In addition, on the afternoon of August 29th, He Lifeng, member of the Political Bureau of the CPC Central Committee and Director of the Central Financial and Economic Affairs Commission, met with Ray Dalio, founder of Bridgewater Associates, in Beijing, emphasizing the deepening of mutually beneficial cooperation between U.S. companies and China This series of signals indicating the stabilization and even marginal recovery of Sino-foreign economic and trade relations has played a marginal boosting role in the market.

3. At the same time, there are signs of marginal acceleration in fiscal efforts recently. However, September-October may be a "window" for further and more substantial adjustments in fiscal policy, and monetary policy may also be further loosened. These marginal changes also have a certain boosting effect on market confidence. Central + local government fiscal expenditures in July increased from a year-on-year growth rate of -4.9% in June to +3.7% in July. However, fiscal expenditure growth from March to June this year lagged significantly, with a monthly average year-on-year decrease of 1.3%. On the other hand, central + local government fiscal expenditures from January to July this year still decreased by 2.1% year-on-year, significantly lower than the budgeted year-on-year growth of +7.9%—considering that the annual fiscal expenditure budget is 28 trillion yuan, the current annualized expenditure progress is lagging behind by nearly 3 trillion yuan (Chart 4). The significant underspending compared to the budget is mainly constrained by weak growth in fiscal revenue, especially the significant drag from the decline in local government revenue. Therefore, market expectations for increasing the budget deficit or government bond quota have significantly increased. Meanwhile, although the issuance of local special bonds accelerated in August, the issuance progress is still slower than the same period in previous years, and may continue to speed up subsequently (Chart 5). Considering that the "window" for annual budget adjustments/issuance of government bonds is in September-October, and the constraints on fiscal easing from the annual budget deficit are already significant, the market anticipates marginal adjustments in fiscal policy and partly reflects the marginal changes in the fiscal stance in July, which is also reasonable. In terms of monetary policy, the central bank has repeatedly stated recently that it will strengthen countercyclical adjustments and study policy measures to increase reserves. If the Fed cuts interest rates in September, it will also open up space for domestic monetary policy easing, especially interest rate cuts. If existing home loan rates can be adjusted, it may marginally boost the real estate cycle.

4. As the US interest rate cut approaches, the opportunity cost of holding US Treasury bonds decreases, which helps to attract funds back to emerging markets. The China-US short-term interest rate spread is expected to narrow rapidly, which may further reduce the opportunity cost of holding dividend-paying assets in Hong Kong, and may also marginally promote exporters and financial institutions in the country to settle foreign exchange. Currently, with market adjustments, the dividend yield of Hong Kong stocks has reached 4.3%, significantly higher than the 3% of A-shares (Chart 6). If the Fed lowers short-term rates from the current level of around 5.25-5.5% to between 3.25-3.5%, it will significantly reduce the opportunity cost of holding assets in Hong Kong, especially stable return products. At the same time, since 2022, as the Fed has rapidly raised interest rates, the China-US short-term interest rate spread has widened, and the willingness of domestic exporters to settle foreign exchange has continued to decline. Based on the average settlement ratio from 2001 to 2021, it is estimated that domestic exporters may have over $540 billion (about 3.8 trillion yuan) in export income unsettled since 2022 (Chart 7); even using the lower average settlement ratio since July 2018 (52.3%), the overseas income unsettled since 2022 may also reach $100 billion (about 740 billion yuan). In a sense, reducing settlements is also a manifestation of RMB "carry trade." With the narrowing of the Sino-US interest rate spread due to the Fed's rate cuts, there is a possibility of a temporary reversal in carry trade involving the Renminbi - and a stronger Renminbi may further promote willingness for capital outflows. At the same time, the proportion of foreign exchange assets held by financial institutions is also sensitive to the short-term interest rate spread between China and the US, which may lead to an increase in future demand for capital outflows (see Chart 8).

The marginal increase in Renminbi exchange rate has enhanced the attractiveness of Hong Kong assets. The recent strengthening of the Renminbi against the Hong Kong Dollar has undoubtedly played a role in easing monetary/financial conditions for China's Hong Kong, a small open economy. In a sense, the effective exchange rate of the Hong Kong Dollar (i.e., the exchange rate against the Renminbi) has depreciated, marginally alleviating downward pressure on asset prices in Hong Kong. As a result, there has been a certain degree of "positive feedback loop" between the Renminbi and overseas Renminbi assets in recent days. Since China's Hong Kong's largest trading partner is mainland China, the trend of the nominal effective exchange rate mainly depends on the exchange rate of the Hong Kong Dollar against the Renminbi. As the Hong Kong Dollar is pegged to the US Dollar, a stronger Renminbi against the US Dollar implies a weaker Hong Kong Dollar against the Renminbi, thereby easing financial conditions in Hong Kong (see Chart 9). Under the linked exchange rate system (i.e., currency board), Hong Kong mainly adjusts its relative competitiveness through changes in local prices and asset prices, so loose financial conditions help alleviate downward pressure on asset prices in Hong Kong (refer to "Can the Heat of the Hong Kong Property Market be Sustained and Replicated after the Spicy Withdrawal?", 3/18/2024).

From the perspective of trade surplus, real exchange rate, etc., the Renminbi's real exchange rate is highly competitive in global trade, and in terms of relative prices, there is no fundamental support for nominal exchange rate depreciation of the Renminbi. China's comprehensive cost and efficiency advantages in the manufacturing industry have accelerated in recent years (refer to "Upgrading and Reshaping of China's Export Industry Chain", 4/16/2023). Since 2020, China's cumulative increase in the PPI index in US dollars is 30-40 percentage points lower than that of Europe and the US, and the cumulative increase in the export price index in US dollars is also about 30 percentage points lower (see Charts 10 and 11). Therefore, in recent years, China's share of global exports has continued to rise, the proportion of trade surplus to GDP has remained high, both indicating an increase in the competitiveness of the Renminbi (see Charts 12 and 13). At the same time, since April 2022, the nominal effective exchange rate of the Renminbi has retraced by 4.9%, the real effective exchange rate has decreased by 13.2%, a decline exceeding all other depreciation cycles since 1990 (see Chart 14) Due to the fact that China's manufacturing value accounts for one-third of the global total, China is the most important "marginal pricing country" in global trade. Therefore, a characteristic that distinguishes the cycle of RMB appreciation and depreciation from that of smaller countries is that the RMB effective exchange rate cycle has a strong "self-limiting" feature. Taking depreciation as an example, when the RMB exchange rate accumulates a certain level of depreciation, the exchange rates of other countries also need to adjust correspondingly to hedge against this impact, limiting the momentum for further depreciation of the RMB. Fundamentally, the growth of China's external demand and trade surplus, due to its large scale, is also difficult to maintain a "linear extrapolation" growth rate. Building on a trade surplus of USD 822.1 billion in 2023, the cumulative year-on-year growth from January to July this year has once again increased by 7.9%, reaching 40% of the total global trade surplus. This proportion indicates that the relative price of the RMB is already highly competitive. Undoubtedly, other factors including carry trades may affect cross-border capital flows, such as the occurrence of carry trade reversals when the Federal Reserve cuts interest rates, which may lead to inflows of cross-border capital.

Looking ahead, short-term factors including the pace of Fed interest rate cuts, the trend of the Chinese cycle, especially the rhythm and magnitude of fiscal easing, will largely determine whether the RMB exchange rate can maintain relative strength. Recent macroeconomic data shows that domestic demand growth momentum and the real estate cycle are still weak. If the expectation of strong fiscal easing can be quickly realized, the RMB exchange rate and the recent relative strength of overseas assets may still have momentum. A significant amount of fiscal easing is an important support for achieving the annual economic growth target—given that fiscal expenditure needs to increase by an annualized level of 2-3 trillion yuan to maintain a neutral fiscal policy stance (i.e., expenditure growth roughly in line with nominal GDP growth). Additionally, whether real estate easing policies, including monetary policy, can effectively stabilize real estate price expectations is also an important determinant of the RMB's trend. Furthermore, effective prevention and resolution of financial risks will help stabilize expectations for the RMB exchange rate. Of course, if the Fed cuts interest rates more than expected, it may exacerbate the reversal of RMB carry trades and marginally boost the short-term relative attractiveness of RMB assets.

In the medium to long term, whether economic market-oriented reforms and fiscal and tax system reforms can bring new growth points and efficiency improvements to the Chinese economy may be the fundamental factors determining the RMB exchange rate trend. The "Decision" of the Third Plenary Session of the Twentieth Central Committee proposed deepening reforms in areas such as new urbanization, land, fiscal and tax system reform, promoting technological innovation, and expanding high-level opening up, which will help improve resource utilization efficiency, enhance total factor productivity (TFP), and more sustainably expand domestic demand. If reforms can improve economic operational efficiency and continuously enhance total factor productivity, they will provide medium to long-term support for the real exchange rate of the RMB Authors: Yi Yun (S0570520100005), Chang Hui Li (S0570520110002), Source: Huatai Securities Research Institute, Original Title: "Huatai | Macro: Exploring the recent strengthening of the Renminbi"