From Robin Brooks, chief FX strategist:
After the weakening of the RMB fix against the Dollar by 1.5 percent in December, the first full week of 2016 saw the pace of depreciation pick up, with the $/CNY fix weakening a further one percent. Besides the faster pace, the recent devaluation trend is notable because the Dollar has traded sideways versus the majors over the past month. Our China economists on Friday lifted their 12-month forecast for the $/CNY fix to 7.00 from 6.60 previously, while also raising their end-2017 forecast to 7.30 from 6.80 before, in part because year-to-date moves may signal a different reaction function of the authorities and because of their long-standing view that the cyclical picture remains weak. We complement that forecast change by giving some context to recent moves and provide some interpretation of what policy intentions might be.
China's balance of payments has seen large capital outflows over the past year, which some argue makes large-scale devaluation inevitable. We caution against treating capital outflows as an exogenous variable, which marches to its own tune. After all, the two months in 2015 with the largest outflows were August and December, months when the authorities devalued the RMB. Our point here is not that there isn't some "steady state" capital outflow, as Dollar-denominated liabilities are gradually unwound. After all, there were outflows last September and October, when - after the shock of the mini-devaluation in August - RMB fixed stronger. Instead, our point is that the authorities heavily influence the pace of capital outflows via the $/CNY fix (a policy variable), and thus - by extension - the drawdown in official FX reserves they need to absorb. This point is important, because it means that the balance of payments is not "out of control," a comment we often hear. The opposite is true. A large and growing current account surplus - our last FX Views estimated it at $300 bn in 2015, likely to grow to $360 bn in 2016 - means that China is well equipped to absorb "steady state" outflows. The puzzle is why China weakens the RMB periodically, given that this fans fears of a larger devaluation, exacerbating outflows and thereby - endogenously - reserve losses.
One reason could be their stated objective of making the RMB more flexible and market determined (note that the intention to devalue the RMB has been repeatedly denied by the authorities). If this is what is going on, it helps to recall that the current account is typically weakest in the first quarter, a well-known seasonality that doesn't just reflect Chinese new year. Between 2006 and 2015, the current account surplus has been $43 bn in Q1, $61 bn in Q2, $68 bn in Q3 and $78 bn in Q4 on average, making fundamentals for the currency the weakest in the first quarter. If a policy objective is to make the exchange rate more flexible and market determined, the first quarter is no doubt a prime candidate for weakening the RMB. Subsequent quarters could then see relative RMB strength, as the current account rises and flows improve. The revised forecast for the $/CNY reflects this rationale, by front-loading RMB weakness and noting that volatility, in addition to direction, may be at play in recent developments.
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