MUCH has changed for the RMB this year. It started off strong, but then policy-induced volatility saw some depreciation pressure. However, the RMB internationalization process has stayed intact. If anything, less speculative pressure surrounding the RMB has led to a greater willingness by policymakers to introduce reforms.

In the second half and into 2015, the RMB will remain influenced, sometimes in different directions, by China’s growth outlook, measures to make the currency more market determined, and ongoing interest rate liberalization. The RMB story will continue to evolve rapidly.

Here, we update our RMB Q&A report — designed to keep readers up to speed with the RMB’s changing story. In this report, we use RMB to refer to the Chinese currency, CNY for the RMB exchange rate in onshore markets and CNH for the deliverable RMB exchange rate offshore.

Q1

What is the H2 outlook for the RMB after its weakness earlier this year?

The RMB started recovering in June but remains an underperformer year-to-date. The onshore CNY and offshore CNH ranked 138th and 109th out of 176 currencies in their performance versus the US dollar year-to-date as tracked by Bloomberg. We believe the RMB will strengthen moderately versus the dollar in the second half, due to stabilizing growth and supportive trade flows.

However, the recovery could be initially tempered by capital account outflows that started in the second quarter. We also expect the currency to trade with greater volatility amid capital account liberalization and an upcoming shift in the US interest rate outlook.

Spot RMB has steadied since mid-June, in line with China’s stabilizing growth and inflation conditions. This confirms our thinking that the change in forex policy earlier this year was not specifically aimed at trying to weaken the CNY to support growth. China still has many other policy tools and CNY depreciation is only going to be the last resort.

Meanwhile, the RMB’s interest rate differential versus the dollar, euro, pound and yen remains supportive. Credit and M2 growth have rebounded from March’s low, which reduced expectations of an immediate cut to China’s reserve requirement ratio.

Exports and imports have also rebounded since May. China’s Ministry of Commerce is cautiously optimistic about second-half exports, and it expects imports to lag due to weak commodity prices. The trade surplus in the first half was US$103 billion, only slightly lower than last year’s US$108 billion.

Considering that China’s trade surplus tends to be back-loaded, the trade balance should be supportive of the RMB in the second half. But the broader trend is for a narrower current-account surplus. Indeed, China’s current-account surplus thinned to 1.5 percent of GDP in the first quarter, the lowest since 2002.

Capital account outflows have started. China’s second-quarter forex reserves rose by US$40 billion, significantly less than the US$130 billion increase in the first quarter. This happened even though the trade balance rebounded and the direct investment surplus was stable, and thus suggests that a sizeable amount of hot money inflows seen in the first quarter has now reversed.

Q2

Spot RMB has stabilized, but why are RMB forward points still elevated?

Although spot RMB has stabilized, US dollar-RMB forward points have stayed elevated. We expect this situation to persist in the near term as importers cover their short forex positions by buying dollar-RMB forwards. Indeed, the correlation between forward points and hot money flows is strong in China.

The fact that forward points no longer track spot and forex expectations as closely as before should not be surprising. RMB forex forward curves are reflecting interest rate parity conditions better as China’s capital account is gradually opening up.

RMB liquidity conditions can be volatile, affected by seasonality and banking regulations. The Lunar New Year and June periods tend to see tighter funding conditions and, hence, higher forex forward points. But these linkages are still developing. The relationship between interest rates and forex still breaks down on occasions. For instance, in the second half of 2013, China’s interest rates rose sharply, yet onshore forex forwards kept declining.

Q3

Why have CNH funding rates risen?

The offshore RMB liquidity pool has risen rapidly, to more than 1.5 trillion yuan (US$238 billion), as measured by global CNH deposits. RMB trade settlement is the biggest generator for offshore RMB liquidity, as imports settled in RMB exceed exports.

In the first quarter, there were 315 billion yuan of trade-settlement outflows from China. RMB-denominated foreign direct investment and Qualified Foreign Institutional Investors repatriated some of this offshore liquidity, but the size of these offsetting flows remains small.

Despite this increase in liquidity pool, offshore RMB funding rates have risen, mirroring the situation onshore. We offer a few explanations for higher rates:

1) As more Chinese corporates go abroad, their larger presence in the offshore market has resulted in a stronger capability to close the onshore-offshore price differential, in both the spot and forward markets.

2)  Rising participation of banks, especially Chinese banks, in the offshore RMB market has resulted in a greater volume of funding activities that can better link onshore and offshore interest rates.

3)  The recent relaxation of inter-company loans and the cross-border guarantee program, as well as developments in the free-trade zones on the mainland are likely to lead to stronger demand for offshore borrowing and result in a smaller onshore-offshore interest rate differential.

4)  Offshore financial institutions were recently allowed to deploy funds more efficiently onshore and offshore.

Q4

Is there any seasonality in China’s forex flows?

There is a degree of seasonality behind the underlying forex flows that move the RMB. Monthly inflows tend to be strong in the first quarter, and to a lesser extent the fourth quarter. Inflows are at their weakest in the second quarter.

In the past, when the RMB delivered steady appreciation through the year, corporates — mainly exporters — naturally chose the first quarter to sell forex forwards in order to minimize the loss from potential RMB appreciation. The fourth quarter also tends to see greater supply from exporters as their proceeds increase ahead of the Western holiday period.

Q5

Does RMB weakness conflict with RMB internationalization?

Rather than steady appreciation, we believe two key features of a reserve currency are actually macroeconomic stability — a low risk of hyperinflation or deflation — and a certain degree of forex flexibility — symptomatic of a deep and liquid currency market.

The Chinese economy is remarkably stable due to vigilant policy fine-tuning. However, RMB volatility is too low. Such low volatility could attract too much speculative inflows that put persistent upward pressure on the RMB. Within reason, greater RMB flexibility would also help to develop the respective offshore loan market, which is much smaller than the pool of liquidity.

RMB weakness seen earlier this year did not derail internationalization efforts when considering:

1)  Dim sum bond issuance was robust. A record 366 billion yuan of bonds and certificates of deposits (CDs) were issued in the first half.

2)  Offshore RMB turnover continued to grow.

3)  The spot basis between the onshore CNY and CNH has re-converged and stayed tight.

4)  Offshore RMB deposits kept rising.

5)  RMB trade settlement increased. Average monthly RMB trade settlement rose from 320 billion yuan in 2013 to 480 billion yuan in 2014. As at end of the first quarter of 2014, 18 percent of China trade was settled in RMB.

Q6

Is the RMB undervalued or overvalued?

A number of currency valuation metrics suggest the RMB is now only moderately undervalued, hence zero to 5 percent away from “fair value.”

It may be argued that absolute valuation matters less than relative valuation, and ranking most currencies in our coverage universe by various metrics suggest the RMB is not particularly undervalued from a relative perspective either.

The large increase in forex reserves is frequently cited as indicative of an undervalued exchange rate. We note that after growing at a rapid pace of about US$450 billion per year in 2007-10, reserves growth slowed in 2011 to US$330 billion and in 2012 to US$130 billion. That was in line with the generally smaller trade balances and suggests a less interventionist approach by the People’s Bank of China and the State Administration of Foreign Exchange.

However, forex reserves surged last year by US$510 billion, leading to criticism that China had reverted to its earlier ways. Reserves rose US$170 billion in the first half this year, mostly in the first quarter.

We do not believe the recent surge in China’s FX reserves should be regarded as indicative of RMB undervaluation. It reflects the capital-account imbalance rather than a current-account imbalance, and the former reflects policy distortions rather than market arbitrage of an undervalued currency.

Capital account liberalization is progressing but is doing so unevenly. Some researchers believe China will likely see net capital outflows when it liberalizes its capital account, which would suggest that the currency is not particularly undervalued.

On the opposite side of the valuation argument, we note three symptoms of overvaluation in China’s data:

1)  Persistent producer price, import and export price deflation, as well as a switch in consumer price inflation drivers from goods to services over the past two-to-three years;

2)  Weak industrial profit growth since 2012, averaging less than 10 percent year-on-year;

3)  Slowing gains in China’s export market share in the US and eurozone.

Q7

What will happen to the RMB when the US Federal Reserve raises rates?

Much has been said about how emerging market currencies will come under pressure when the Fed raises interest rates. High global funding rates and a slowdown in capital inflows, or even capital outflows, could reveal the structural vulnerabilities of these currencies, such as current-account deficits, fiscal deficits and highly leveraged household or corporate sectors.

We do not believe the RMB will come under that kind of pressure, although the Fed’s eventual tightening would engineer greater volatility for dollar-RMB.

Another angle is the interest rate differential between China and the US. The median forecast among Federal Open Market Committee members is for the Fed funds rate to rise to 1-1.25 percent by the end of 2015, and to 2.5 percent by the end of 2016. But this does not necessarily mean an erosion of China’s interest rate advantage. Over the next two years at least, China’s monetary policy would remain relatively restrictive, as the new government tries to balance downside risks to growth and rising debt.

Q8

Are there risks to the RMB from China’s external debt and commodity trade financing?

China’s external debt as a share of GDP has actually moderated slightly over the past decade from 13.4 percent in 2003 to 9.4 percent today. Even if we were to modify the statistics by adding the outstanding amount of CNH bonds issued by Chinese entities — around US$80 billion as of the first quarter of 2014 — China’s external claims would still amount to around 10.5 percent of China’s GDP, far lower than in most other Asian economies.

Most of China’s reported external debt is short-term in nature, and more than half is related to trade financing, be it from banks or in the form of cross-border inter-company trade credit. Concerns over the unwinding of commodity trade financing have risen lately after reports of loan fraud in Qingdao.

Q9

What are the recent RMB reforms?

Over the past year, there have been a number of notable onshore CNY market developments, such as widening of the onshore dollar-CNY trading band in March. The Shanghai Free Trade Zone was launched last September and key implementation details on free trade accounts were announced in May this year. The authorities also introduced more deregulation of cross-border flows and, more generally, simplified procedures.

Regarding offshore RMB developments, we noted key currency swap agreements with the European Central Bank and Swiss National Bank in October 2013 and in July 2014. The UK, Germany, France, Luxembourg and South Korea were either assigned RMB clearing banks or signed memos of understandings.

The Shanghai Free Trade Zone was launched in September 2013. The zone is being used a testing ground for investment, trade and financial reforms, before a nationwide rollout. For forex, the most important development is the implementation of free trade accounts.

The major implication of the free trade account system, as it now stands, is that companies within the zone will have better access to offshore markets. Demand for the offshore RMB will be further supported by the recent relaxation of cross-border guarantee rules.

The authorities intend for greater deregulation of cross-border forex flows, although implementation details have not been released. We can eventually expect companies and individuals within the zone to be able to make portfolio investments overseas and to invest in onshore capital markets. Issuance of “panda bonds” will also be deregulated for companies in the zone.

Once these are implemented, there will be a de facto opening of the capital account in the free trade zone, and full convertibility of the RMB within it. The next step from there will be a nationwide rollout. We expect the RMB to achieve full convertibility within the next two to three years.

Q10

RMB reforms — what’s next?

There have been many RMB reforms announced in recent months. And there is no reason to believe that this process will slow anytime soon.

A few conclusions can be drawn:

1)  The Chinese financial system needs to be more integrated globally. The sum of China’s external assets and liabilities comprise 104 percent of GDP at the end of 2013, compared with an average of 284 percent in the G3. Even within BRICS, financial and investment openness in China needs to catch up with South Africa and Russia.

2)  China’s external assets are heavily skewed toward official reserves, whereas external assets in the G3 are more evenly distributed across direct investment, portfolio investment and banking sector assets. While such a pattern is not uncommon amongst emerging economies, China’s outward direct investment and external portfolio assets are very low and its reserve accumulation excessive even compared to the other BRICS.

3)  China’s liabilities are skewed toward direct investment, far more so than its BRICS counterparts. Correspondingly, its portfolio investment liabilities are very small. While this has shielded China from portfolio outflow risks, it also reduced international exposure in the areas of accounting standards, risk management and financial product development, and stymied the development of the financial market.

To alleviate these imbalances, we expect a higher degree of investment abroad by both Chinese corporates and individuals. The former has been accelerating for some time but still needs greater flexibility.

We have seen specific rules to support overseas direct investment recently. The upcoming Shanghai-Hong Kong Stock Connect, which allows investors to trade on each equity market exchange, should lead to convergence between the two markets. It will help promote RMB internationalization.

Steven Sun, our head of China Equity Strategy, expects the new scheme to be launched in October, and it could be expanded in time to cover Shenzhen’s A-share market or beyond.

We believe RMB liquidity in the offshore market is large enough to support the new scheme, in particular considering there will be initial limits.

The article was jointly written by Paul Mackel, Ju Wang, Dominic Bunning and Joey Chew with The Hongkong and Shanghai Banking Corporation Limited. The opinions expressed here are their own.