On September 19, 2024, following the Federal Reserve's initiation of interest rate cuts, the Chinese yuan exchange rate moved from the 7.1 range to the 7.0 range. On September 24, a series of policies aimed at stabilizing growth in China's financial sector were introduced, further strengthening the yuan's exchange rate and even breaking through the "7" mark. As the appreciation of the yuan increases, there has been a growing divergence of opinions regarding the direction of the yuan's exchange rate.

Question One:

How much appreciation potential does the yuan still have?

Answer: Compared to the decline of the US dollar, the appreciation of the yuan in this round is not significant, which may imply expectations for the fundamentals of China's economy and the tense external environment.

The appreciation of the yuan exchange rate in this round started on July 25, rising from 7.28 to 7.04 on September 24, with an appreciation of 3.3% over two months. However, the main reason is the weakening of the US dollar. The decline of the US dollar index in this round began about a month earlier than the appreciation of the yuan, falling from 106 on June 27 to 100.4 on September 24, with a decline of 5.4% in less than three months. The yuan's trend lagged behind the US dollar, reflecting the previous strong expectation of yuan depreciation; at the end of July, the yuan finally started to appreciate, catalyzed by the sharp rise of the yen during the same period. Regardless of the pace experienced in the middle, fundamentally, the appreciation of the yuan in this round is an inevitable result of the weakening of the US dollar, and compared to the decline of the US dollar and the appreciation of other emerging market currencies, the current yuan exchange rate is not too strong.

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Since the "811" exchange rate reform in 2015, the yuan exchange rate has established a general correlation with the US dollar index. Based on the overall same direction of the two, the yuan's strength or weakness is presented based on the changes in the fundamentals of China's economy. From August 2015 to the beginning of 2016, the core logic was that after the exchange rate reform, the yuan made up for the depreciation and sought a new reasonable central point. From 2016 to 2017, China's economy regained vitality in the "three cuts, one reduction, and one supplement" and the global economic recovery, thus ending the process of seeking the bottom of the yuan exchange rate (within 7), and appreciating sharply with the weakening of the US dollar. Until 2018, the United States initiated a trade war, and concerns about the decoupling of China and the United States prompted the yuan exchange rate to depreciate sharply and eventually "break 7".

From 2020 to 2021, the global pandemic gradually highlighted the advantages of China's supply chain, and the yuan experienced a magnificent appreciation, especially at the end of 2021 and the beginning of 2022, when the US dollar strengthened and the yuan continued to appreciate in the "highlight moment". At that time, the market was filled with optimistic expectations for the internationalization of the yuan, and the voice of the yuan "breaking 6" also emerged. The emotional reversal began in April 2022, with the outbreak of the Russia-Ukraine conflict, the yuan made up for the depreciation and followed the sharp rise of the US dollar to reach a peak of 7.35. Since 2023, the yuan has generally weakened in line with the US dollar, mainly reflecting that after the relaxation of epidemic prevention, the strength and sustainability of China's economic recovery were not as expected, and with the baseless criticism of China's "overcapacity", international trade and economic tensions have heated up.

From the perspective of the overall correlation with the US dollar, the current yuan exchange rate still has a considerable appreciation potential. If the prospects for China's economic growth are significantly positive and international trade conflicts are eased, with the current level of the US dollar, it can be expected that the yuan will rise to around 6.8-6.9; but if these two suppressors are still present, the current position of the yuan exchange rate and the relationship with the US dollar are generally balanced (since the beginning of 2018, the cumulative change in the US dollar index and the US dollar exchange rate against the yuan has been roughly the same so far, with the yuan being slightly stronger); if international trade conflicts intensify in the future, the yuan still has the potential to weaken relatively.

Question Two:

How much impact will the Federal Reserve's interest rate cuts have?Answer: Currently, the US Dollar Index has already largely priced in expectations for Federal Reserve rate cuts, and it is necessary to be vigilant that China may not necessarily be the primary destination for this round of US dollar capital outflows.

Since the fourth quarter of 2023, the US Dollar Index has mainly fluctuated around expectations for Federal Reserve rate cuts. According to the Federal Reserve futures reflected by the FedWatch Tool, which indicates the probability of rate cuts, the US Dollar Index is highly correlated with market expectations for the number of rate cuts. The significant weakening of the US Dollar Index in this round is mainly accompanied by weaker US employment data and downward inflation data, leading to a significant upward revision of expectations for Federal Reserve rate cuts. At present, the market expects a total of about 125 basis points (bp) of rate cuts for the year 2024, which means there will be one more 50bp and one 25bp rate cut in the last two meetings of the year; the expectation for rate cuts in the first half of 2025 is about 100bp, which means a 25bp rate cut at each meeting. Compared to the situation shown in the September 2024 Federal Reserve dot plot, market expectations are clearly ahead of the judgments of the Federal Reserve policymakers. Among them, nine policymakers believe that another 50bp rate cut within the year is sufficient, and only one policymaker agrees with the market, believing that another 75bp rate cut is appropriate; for 2025, five policymakers believe that another 100bp rate cut for the year, five believe 125bp, and two believe 150bp, which is also less than the market's expectation of a 100bp rate cut in the first half of the year. Therefore, the current US Dollar Index should be said to have priced in a relatively sufficient expectation for Federal Reserve rate cuts.

Looking at the performance of the US Dollar Index before and after rate cuts historically, the current decline in the US Dollar Index is close to the decline during the recessionary rate cuts in 2001 and 1998. However, the US economy has not yet shown any conclusive signs of recession, so the decline in the US Dollar Index may be somewhat "excessive". After the September interest rate meeting, Powell tried to define this significant rate cut as a "calibration", while continuously emphasizing that the absolute level of the job market remains strong. In the circumstances of the Federal Reserve's "preemptive rate cuts" in 1989, 1995, and 2019, the US Dollar Index rose after the rate cuts. The significant decline in the dollar before this rate cut is related to the larger fluctuations expected by the market. At the end of May this year, the market still expected only one 25bp rate cut for the whole year, causing the strong dollar to last too long. The market's rate cut expectations, which are ahead of the Federal Reserve, also have the possibility of being calibrated.

In addition to the impact of rate cut expectations, the recent decline in the US Dollar Index has also been exacerbated by the strong yen. Among the six constituent currencies of the US Dollar Index, the euro has a weight close to 60%, and the US Dollar Index is highly consistent with the dollar-euro exchange rate. However, since 2023, the fluctuation center of the US Dollar Index has been significantly higher than that of the dollar-euro exchange rate, and the biggest influencing factor is the significantly weak yen. Therefore, the strong rebound of the yen in July this year has also had an undeniable drag on the US Dollar Index. On September 20, the Bank of Japan decided to stand still, but Haruhiko Kuroda indicated that although two rate hikes have been made, Japanese interest rates may still be below the neutral rate. The overall direction of the normalization of Japanese monetary policy remains unchanged, and the prospect of further strengthening of the yen may suppress the US Dollar Index.

Every time the Federal Reserve starts a rate cut cycle, it will lead to capital inflows into emerging markets, which is beneficial for the performance of emerging market assets. As the most important destination in emerging markets, China has benefited more since the expansion of its capital market in 2018. Overseas funds have flooded into the bond and stock markets, also becoming a supporting force for the renminbi exchange rate. However, during the process of the US Dollar Index weakening since July, the net inflow scale of China's stock and bond funds has been limited, while the net inflow scale of other emerging markets has significantly expanded. This is related to the decline of the A-share market and the narrowing of the renminbi swap points during this period (leading to a slowdown in foreign capital allocation to Chinese bonds). If China's capital market's attractiveness to capital significantly increases in the future, under the background of the Federal Reserve's rate cuts, the re-allocation and even increased allocation of foreign capital to Chinese assets will also become a booster for the appreciation of the renminbi.

Question Three

How to view the so-called "hoarding foreign exchange"?

Answer: The settlement of hoarding foreign exchange is a catalytic factor for the appreciation of the renminbi in this round, but it is more a result of the fluctuation of the renminbi exchange rate rather than the cause.

The domestic "hoarding foreign exchange" in this round started to accumulate gradually from October 2022, and it can be said that a small climax was formed from April to July this year. We observe this trend by excluding the settlement rate of foreign exchange receipts and payment purchase rates for forward performance, from which we can draw three inferences:

Firstly, in recent years, there has been a process of "hiding foreign exchange among the people". Unlike the more obvious directional fluctuations in the payment purchase rate, the settlement rate of foreign exchange receipts has a higher degree of fluctuation, and the fluctuation center has tended to move downward in recent years, with a relatively smaller response to the direction of the renminbi exchange rate. This means that after foreign trade export enterprises earn foreign exchange, they tend to retain a larger proportion of it, especially during the significant appreciation of the renminbi from 2020 to 2021, the settlement rate of foreign exchange receipts did not increase due to the appreciation of the renminbi, indicating that the main consideration for enterprises to retain foreign exchange may be practical needs such as convenience of payment and overseas investment, rather than purely speculative factors.Secondly, the correlation between the remittance purchase rate and the trend of the RMB exchange rate is better. The strength or weakness of the RMB exchange rate has a greater impact on whether enterprises use their accumulated foreign exchange or purchase foreign exchange from banks when making external payments. When expecting the RMB to depreciate, enterprises tend to purchase more foreign exchange from banks, thereby accumulating more foreign exchange. In April 2022, the RMB began to depreciate, and until September of that year, the actual purchase of foreign exchange was not significant. However, in October 2022, when the RMB further depreciated and broke through 7.1, it triggered the willingness to purchase and hoard foreign exchange.

Again, the decision to hoard foreign exchange is mainly related to the "expectation" of the trend of the RMB exchange rate. We can use the purchase rate minus the settlement rate to more comprehensively show the willingness to hoard foreign exchange. Looking at the relationship between this indicator and the RMB exchange rate, the change in the willingness to hoard foreign exchange is often significantly lagging behind the change in the RMB exchange rate. In addition to the example of the RMB turning from appreciation to depreciation in 2022 mentioned above, for example, in 2020, the RMB started to appreciate from June, but the willingness to hoard foreign exchange did not significantly decrease until November, corresponding to the RMB exchange rate breaking below 6.7, which was about a 6.5% decrease from the previous high point of 7.1. Looking back at this round of "hoarding foreign exchange," the continuous increase in the willingness to hoard foreign exchange was actually during the period when the RMB mid-price and market price were separated. Due to the policy layer's regulation of the RMB exchange rate, the market formed an expectation of "should depreciate but temporarily not depreciate," thereby delaying settlement and rushing to purchase foreign exchange. The increase in the willingness to hoard foreign exchange in 2014-16 also occurred when the market's expectation of depreciation was very strong before and after the "811" exchange rate reform in 2015.

After this round of RMB appreciation, the adjustment of the hoarding foreign exchange plate was rapid. In August, the remittance purchase rate decreased from 69.7% in July to 59.6%, and the collection settlement rate increased from 53.7% to 55.4%, with the difference between the two decreasing from 16 percentage points in July to 4.1 percentage points. This is related to the long-term persistence of the previous hoarding behavior. The change in enterprises' demand for foreign exchange from strong to weak undoubtedly played a certain role in promoting the appreciation of the RMB.

Will this adjustment go further in the future? On the one hand, it depends on the market's view on whether this round of RMB appreciation is sustainable. We use the hoarding foreign exchange willingness indicator to calculate the weighted average of the RMB exchange rate from October 2022 to July 2024, which can be concluded that the average cost of this round of hoarding foreign exchange is about 7.1661. Using the same method to calculate the weighted average of the US-China 1-year Treasury bond yield spread, it can be concluded that the average yield of holding US dollars is about 3.15%. Therefore, when the RMB breaks below 6.95, the hoarding foreign exchange plate will face overall losses. At this time, if the market expects the RMB exchange rate to stabilize and operate within 7, then the willingness to hoard foreign exchange may collapse, and panic settlement may occur, leading to a sharp rise in the RMB exchange rate and a certain degree of over-adjustment. However, if the market's view on the RMB exchange rate is still above 7, then this round of adjustment of the hoarding foreign exchange plate may have been relatively sufficient.

On the other hand, it also depends on the actual need for the market to hold foreign exchange. Since 2022, Chinese enterprises have been rapidly going global, and the construction of the "Belt and Road" contains the need for foreign investment. The corresponding labor going overseas will also bring foreign exchange demand under the service trade. In recent years, the centralization of the collection settlement rate has been affected by the increase in this part of the actual demand, and the change in the RMB exchange rate will only affect the exchange rate but will not change the trend.

Question 4: What is the core contradiction of the RMB exchange rate?

Answer: Whether strong exports can continue, and whether the foundation for China's stable and long-term economic development can be consolidated.

The basic aspect of the RMB exchange rate lies in cross-border capital flows. Excluding the interference of the willingness to hoard foreign exchange, we directly observe the sub-item situation of banks acting on behalf of customers for foreign-related receipts and payments. At present, the strongest support for China's cross-border capital inflow is that the trade surplus has reached a new high, and the main drag is that the capital and financial project has changed from a surplus pattern to a deficit pattern since 2022. In the capital and financial project, the main drag is that the direct investment project has changed from a surplus pattern to a deficit pattern. Among them, in 2022, as the Federal Reserve raised interest rates and the US-China interest rate spread sharply turned into an inversion, the securities investment project appeared a large deficit, becoming the main source of capital outflow pressure in that year; starting from the second half of 2022, the direct investment project began to continue in deficit, becoming the more important source of capital outflow pressure so far.

Firstly, China's exports are driven by the recovery of the global electronics industry chain, and with the support of low domestic prices, they still have resilience. The main uncertainty lies in external economic and trade conflicts. Since the third quarter, the prosperity of the US manufacturing industry has declined, and the European manufacturing industry has continued to be sluggish, dragging down the global manufacturing PMI, and the market's concern about the slowdown in external demand has increased. However, China's exports have always maintained a medium to high growth rate, showing strong resilience. Looking at the HS2 code classification, the growth of China's exports this year has been mainly driven by mechanical and electrical, audio equipment products, which have shifted from a significant drag to a significant driving force. In addition, the export driving force of non-ferrous metal products has turned from negative to positive with the support of price advantages, making an important contribution. Among mechanical and electrical products, it can be observed that the growth reversal is mainly concentrated in two types of products: integrated circuits and automatic data processing equipment. It can be seen that China's export prosperity has obviously benefited from the recovery of the global electronics industry driven by AI, and thus the correlation with the prosperity of manufacturing in Europe and the United States is not so close.Will the appreciation of the renminbi exchange rate affect export performance? This is also a concern in the market, with many viewpoints suggesting that policymakers may not allow a significant appreciation of the renminbi. We believe that the policy recognition range for the renminbi appreciation may not be that narrow. Since 2023, as China's price level has decreased, the renminbi's real effective exchange rate has been in a rare state of being continuously and significantly lower than the nominal effective exchange rate. The so-called "quantity for price" in exports has also led to baseless accusations from European and American countries about China's "overcapacity." Low domestic prices have provided a buffer for the appreciation of the renminbi exchange rate, making it less likely for the price advantage of Chinese exports to be diminished by renminbi appreciation. On the contrary, the "steady progress" of the renminbi exchange rate will help promote a more favorable positive cycle and accelerate the pace and intensity of global asset reallocation to China.

The biggest threat to China's exports lies in the tightening of external trade and economic policies. First, the European market has become more dependent on China's high-tech manufactured goods and automobile exports to a large extent since the China-US trade war. However, recent actions such as the EU's anti-subsidy investigations into Chinese photovoltaic products and the imposition of tariffs on Chinese new energy vehicles have cast a shadow over the prospects for Chinese exports. Second, there is the possibility of escalated sanctions from the United States, including tightening the rules of origin for tariffs on China, cracking down on "detour" exports; and strict import restrictions on high-tech products represented by chips, thereby increasing the difficulty for China to trade time for space in the high-tech field, affecting the growth of high-tech product exports.

Secondly, the decline in foreign direct investment this year, combined with the trend of enterprises going global, has led to further increased demand for currency exchange, becoming the greatest suppressive force on the renminbi exchange rate. On one hand, from January to August this year, China's actual use of foreign direct investment fell by 31.5% year-on-year (calculated in renminbi). Foreign direct investment not only values China's vast market but also aims to take advantage of the lower labor costs in China. Therefore, foreign enterprises have a higher export orientation. As of July this year, foreign-funded enterprises accounted for less than 20% of the business income of Chinese industrial enterprises, while their share in China's export amount was 27.5%. After the tightening of China-US trade relations, it is inevitable that the degree to which foreign capital values the advantage of China's labor cost will be affected. On the other hand, facing the decline in domestic investment returns, Chinese enterprises are actively seeking greater business opportunities overseas, a trend that may continue in the medium to long term. However, if China's economic momentum strengthens and the downward trend in domestic investment returns is reversed, it is expected to alleviate the pressure of capital outflows under direct investment.

Finally, capital inflows under securities investment depend on the implementation of stable growth policies. Although the China-US interest rate spread is still deeply inverted to this day, by using large state-owned banks to provide dollars to the market through foreign exchange swaps, it has allowed the forward renminbi exchange rate to appreciate compared to the spot price, and foreign capital still has the motivation to flow into the Chinese bond market through foreign exchange swap operations. Since October 2023 up to June of this year, the scale of Chinese bonds held by foreign institutions and individuals has continued to rise, setting a historical high, which is in clear contrast to the trend of a decline in the scale of foreign holdings of Chinese stocks during the same period. Foreign capital allocation to Chinese bonds is concentrated on interbank certificates of deposit, as they have a shorter term and higher yields than short-term government bonds.

In addition to obtaining the yield of Chinese bonds, foreign capital will also gain from the appreciation of the renminbi forward through foreign exchange swap operations. The yield is the foreign exchange swap point/spot exchange rate. As long as the foreign exchange swap point for the US dollar against the renminbi is negative, there is a positive return. We calculate the yield of foreign capital investing in one-year Chinese interbank certificates of deposit (AAA) through foreign exchange swap operations and compare it with the yield of one-year US Treasury bonds and AAA corporate bonds. It can be seen that with the Federal Reserve's interest rate hikes in 2022, the yield on investing in Chinese bonds also rose (thanks to the expansion of the renminbi swap point). By the end of 2022, this return not only exceeded the yield on US Treasury bonds but also rarely surpassed the yield on US corporate bonds. This is a reflection of the policy level's injection of dollar liquidity through foreign exchange swaps to alleviate the depreciation pressure of the renminbi. However, after the rapid appreciation of the renminbi since the end of July, the necessity of policy regulation has weakened, and the attractiveness of foreign investment in Chinese bonds has明显ly weakened, which can also be seen from the slowdown in the increase of foreign holdings of Chinese interbank loans and deposits in August.

Although the momentum of attracting foreign capital inflows through foreign exchange swaps has weakened, the willingness of foreign capital to flow into China may spontaneously increase with greater confidence in China's stable economic growth. On September 24, the central bank announced a double reduction (a 50bp reserve requirement ratio cut and a 20bp interest rate cut), reduced the interest rates on existing housing loans, and created stable stock market monetary policy tools, etc. The reaction of the renminbi exchange rate was to further appreciate by nearly 300 points, without paying attention to the pressure of the narrowing China-US interest rate spread. This once again shows that the fundamental pricing logic of the renminbi exchange rate is confidence in China's economy. Especially under the Federal Reserve's interest rate reduction cycle, whether it is direct investment or securities investment, funds may flow in with the market's increased confidence in China's economy, creating a strong renminbi exchange rate.