market foundation and conditions for maintaining the basic stability...
title：market foundation and conditions for maintaining the basic stability of the rmb exchange rate
ensuring the internal and external balance of the economy stands as a crucial economic and financial objective in china. the communiques issued at the conclusion of the central economic work conferences in both 2022 and 2023 underscored the importance of 'maintaining the rmb exchange rate at a reasonable and balanced level', marking the second instance of such emphasis since the exchange rate reform on august 11, 2015. previously, this emphasis was noted in 2016 and 2017. additionally, during the inaugural central financial work conference, 'strengthening management of the foreign exchange market and preserving the fundamental stability of the rmb exchange rate at a reasonable and balanced level' were identified as medium-term priorities in current and future financial endeavors.
the factors affecting the rmb exchange rate at this stage are interwoven
by the close of 2023, an article highlighted the key factors shaping the trajectory of the rmb exchange rate in 2024: domestic economic recovery, global currency tightening, and the central bank's exchange rate policies. amidst the backdrop of a broadly anticipated 'soft landing' for the us economy, interest rate reductions by the federal reserve (fed), and a weakening us dollar, it was explicitly noted that the rmb exchange rate in 2024 would depend on whether the positive momentum of domestic economic revival could counterbalance the adverse impacts of fed tightening and a robust us dollar.
in 2024, the enhanced fundamentals of the domestic economy have provided a bolstering effect on the rmb exchange rate. in the first quarter, economic growth exceeded expectations, fueled by a resurgence in external demand, driving rapid growth in industrial production and manufacturing investment. concurrently, improvements in personal incomes and employment conditions have sustained the ongoing recovery in final consumption demand, accumulating favorable factors for economic recovery.
conversely, the fed's deviation from easing expectations exerted a downward pressure on the rmb exchange rate. driven by successive instances of higher-than-expected inflation data in the first three months, the market reassessed the fed's stance towards tightening, resulting in a resurgence of the us dollar index and us treasury yields, thereby intensifying the strain on non-dollar currencies. since april, the exchange rates of asian currencies such as the japanese yen, south korean won, and indian rupee vis-à-vis the us dollar have reached recent lows spanning years, or even decades, sparking dialogues regarding the asian financial crisis and an 'asian currency defense war'.
the rmb exchange rate is currently mainly affected by the strong us dollar. in the final two months of 2023, the rmb stabilized after a period of decline, buoyed by the fed's dovish stance and improved global conditions. however, as 2024 begins, the rmb's recovery was impeded by the reevaluation of the fed's tightening outlook. by the end of april 2024, the rmb exchange rate (as indicated by the trading price at 4:30 pm on the china foreign exchange trade system, cfets) had cumulatively depreciated by 2.1% since the end of the previous year, marking its lowest point in last six months.
during the same period, the depreciation of the rmb against the us dollar was more moderate than that of most non-dollar currencies. however, the cfets rmb exchange rate index rose by a remarkable 3.4%. this highlights the resilience of the rmb's performance against alternative currencies. nonetheless, driven by subdued domestic inflation, the real effective exchange rate (reer) of the rmb, compiled by the bank for international settlements (bis), experienced a cumulative decline of 0.5% in the first quarter. this has helped stabilize china's export price competitiveness.
china's foreign exchange market environment is different from seven years ago
with the us economy increasingly likely to avoid a downturn, the fed's less frequent and delayed interest rate cuts are expected to persist as a headwind for the rmb exchange rate in 2024. this inevitably evokes memories of the '8.11' exchange rate reform seven years ago. at that time, partly influenced by the divergence in sino-us monetary policies, the positive interest rate differential between china and the us narrowed, exerting sustained pressure on the rmb exchange rate. over a three- year period from 2015 to 2017, the annual average rmb exchange rate experienced a cumulative decline of nearly 9%. similarly, the rmb exchange rate depreciated in 2022 and in 2023,amounting to a cumulative depreciation of 9%. it appears that 2024 will mark the third consecutive year of rmb exchange rate adjustments.
the solid foundation and conditions for maintaining the fundamental stability of the rmb exchange rate ensure financial resilience. it is noteworthy that although the current foreign exchange market pressure may resemble the initial phase of the '8.11' exchange rate reform in terms of price levels, the foundation of the foreign exchange market today differs significantly from the past.
firstly, preceding the '8.11' exchange rate reform, the rmb witnessed over 20 years of unilateral appreciation since the unification of exchange rates in early 1994, leaving market participants psychologically and practically unprepared for rmb depreciation. however, after the reform, especially after the rmb surpassed the 7 mark against the us dollar in august 2019, the rmb exchange rate showed bidirectional fluctuations, becoming a routine occurrence. market participants are no longer alarmed by exchange rate fluctuations.
secondly, prior to the '8.11' exchange rate reform, the private sector had accumulated substantial net external debt due to the prolonged unilateral trend. during the initial stages of the '8.11' exchange rate reform, the unexpected rmb depreciation triggered a pro-cyclical response from market participants to bolster overseas asset allocation and repay external debts, resulting in a pronounced cross-border capital flow shock characterized by 'capital outflow-reserve depletion-exchange rate depreciation' in china. however, following the concentrated adjustments, by the close of 2023, the private sector's net external debt had dwindled to us$541.5 billion, marking a significant reduction of us$1.83 trillion compared to the levels in late june 2015 (prior to the '8.11' exchange rate reform). private-sector currency mismatches have substantially improved, significantly enhancing the resilience of market participants to the rmb depreciation..
thirdly, with the increasing internationalization of the rmb and the enhanced flexibility of the rmb exchange rate, domestic market participants are increasingly resorting to local currency pricing and settlement, as well as utilizing foreign exchange derivatives tools to mitigate and hedge against exchange rate risks. their adaptability and resilience to exchange rate fluctuations have significantly improved. in recent years, the domestic foreign exchange market has generally exhibited an operational trend of 'selling foreign exchange at high points and buying foreign exchange at low points'.
the solid foundation and conditions for maintaining the fundamental stability of the rmb exchange rate ensure financial resilience. this assessment is based on factual data rather than anecdotal accounts. 2023 marked the second year of the ongoing rmb exchange rate adjustment cycle. from the perspective of bank foreign exchange settlements and sales, as well as cross-border capital flows, some notable changes have indeed occurred compared to the previous year, with both bank foreign exchange settlements and sales, and bank agency cross-border payments and receipts recording deficits for the first time since 2019.
however, upon comparing the variances in bank spot and forward foreign exchange transactions, the deficit of us$43.6 billion in 2023 is substantially lower than the deficits of us$571.2 billion in 2015, us$369.5 billion in 2016, and us$89.3 billion in 2017. similarly, the deficit in bank agency cross-border payments and receipts stood at us$68.7 billion, significantly lower than the figures of us$194.0 billion, us$305.3 billion, and us$124.5 billion in 2015, 2016, and 2017 respectively. the current imbalance in foreign exchange supply and demand, as well as the intensity of volatility in capital flows, appears to be less significant than in previous years.
data on the balance of payments can further confirm the previous assessment
data on foreign exchange settlement and sales, as well as agency cross-border receipts and payments provided by banks, serve as unique indicators in china's foreign exchange payment statistics system, while balance of payments data offers a more internationally comparable perspective. analysis of balance of payments data can further support earlier conclusions.
market concerns regarding rmb depreciation potentially accelerating capital outflows contrasted with the actual trend in 2023, where capital outflow pressure in china tended to converge. throughout the year, the capital account deficit in the balance of payments totaled us$248.2 billion (including net errors and omissions), marking an 18.7% decrease year-on-year. within this, the net outflow of short-term capital, also known as non-direct investment capital flows including net errors and omissions, amounted to us$105.6 billion, a 67.7% decrease.
this phenomenon is attributed to the normal adjustment effect of exchange rate depreciation on capital flows, characterized by 'rewarding inflow and restricting outflow.' in practice, cross-border capital flows involve two main entities: domestic capital (outward investment) and foreign capital (inward investment). in 2023, china's private capital account (non-reserve financial account) saw a net outflow of us$209.9 billion, down by 18.4% from the previous year. among them, private outward investment witnessed a net outflow of us$223.4 billion, a decrease of 6.4%, while private inward investment recorded a net inflow of us$13.4 billion, compared to a net outflow of us$18.7 billion the previous year.
a broader review over time reinforces earlier findings. from 2022 to 2023, china's annual average capital account deficit stood at us$276.8 billion, down 39.3% from the 2015-2017 average.
this highlights the stability of the expectations of domestic market entities during the current rmb exchange rate adjustment cycle, while past measures of 'foreign exchange held by the people' have served as a 'reservoir,' smoothing pro-cyclical fluctuations in capital flows. at the end of 2016, amidst debates on stabilizing exchange rates or reserves, private outward investment outflows amounted to us$675.6 billion, a 1.02-fold increase from the previous year, while foreign investment shifted from a net outflow to a net inflow of us$259.6 billion. the key to maintaining a stable exchange rate is to strengthen confidence in the rmb's value in the onshore market. in 2017, not only did the rmb avoid breaching the 7 mark against the us dollar, but it also appreciated by over 6%, dealing a blow to rmb short-sellers, reshaping exchange rate policy credibility, and successfully rebounding from the '8.11' exchange rate reform.
in recent years, due to a sharp reduction in the private sector's net external debt and significant improvement in currency mismatch, real financial transaction demand under depreciation pressure has been greatly constrained. this was evident in march 2024 when domestic rmb exchange rate fluctuations widened the domestic foreign exchange supply-demand gap. however, this stemmed mainly from weakened market willingness to sell foreign exchange, rather than a strengthened motivation to buy foreign exchange. moreover, compared to the final two months of 2023 (when the rmb stopped falling and rebounded), market willingness to sell foreign exchange increased, while motivation to buy foreign exchange decreased in the first three months of 2024. the exchange rate leverage adjustment effect of 'buying low and selling high' continues to function normally.
from an international perspective, a prerequisite for a successful currency attack is domestic residents and businesses engaged in panic buying and hoarding of foreign exchange. obviously, this situation has not occurred in china. china's experience reaffirms that only with a healthy domestic economic and financial system can the benefits of exchange rate fluctuations and capital flows be fully realized. this underpins china's confidence, ability, and conditions to maintain the basic stability of the rmb exchange rate."
guan tao is the global chief economist of boc international
