RMB cannot follow the dollar surge with an increasingly uncertain recovery

• The surge of the US dollar over the past couple of weeks, although with some respite during the last few days, exerted strong downward pressure on virtually all currencies for emerging economies (EM). The only exception has been the RMB. Its resilience, notwithstanding market volatility, came to a soft – but noticeable – pause last Friday, March, 20.
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• The market optimism about the RMB, which has pushed it to sustain the pressure from the USD, mainly stems from the encouraging news about the rapidly declining new confirmed coronavirus cases and the gradual recovery of production in China. But such confidence, based on a better outlook for the Chinese economy, might not last too long. After all, a global recession will only dampen China’s growth prospect.
• China showed strength in containing the transmission of the coronavirus in a short period of time, but the economic consequences will not be as short-lived. Consumption and investment experienced the largest decline in recent history. As long as the worries about coronavirus still hover over the country, the economy is unlikely to fully recover.
• First, the spread of the coronavirus to a full-fledged pandemic is dampening China’s external demand and disrupting the global supply chain. Second, the collapse of financial markets has worsened sentiment across the board which has been priced in risky assets. China’s financial sector can generally be shielded from the increase in risk aversion in its domestic markets thanks to capital controls, but this is not the case for Chinese issuers (especially high yield ones) that rely on dollar finance. This is particularly important for a key engine of growth in China, namely the real estate sector.
• As the prospect of China’s growth in 2020 is likely to deteriorate because of the collapse in external demand and the surge in global risk aversion, demand policies are bound to become laxer. The key question left will be whether monetary and fiscal policy will be strong enough to offset the negative shocks. In that regards, the PBoC has cut rates and lowered RRR ratio, but the monetary policy transmission mechanism remains weak so that funding costs for the riskier part of the economy have been actually increasing. Fiscal policy, especially infrastructure investment, will be back to the forefront but the shock is too big and too general for such a single instrument to stem off the downward pressure. It seems clear that a weaker RMB may be needed to strengthen the export sector.
• At the same time, the spreading pandemic and its negative impact on global financial markets point to a strong dollar, barring coordinated intervention at the upcoming G10 meeting. In the midst of global financial turmoil, the surge in global risk aversion is increasing risk premium for the EM currencies. For China, the risk sentiment is more concerning because the US-China trade war has dramatically changed the relationship between China and the US, albeit the implicit agreement in the Phase 1 deal. As a result, the US dollar shortage across the board will make it increasingly costly for the RMB to follow the US dollar. Therefore, the RMB cannot be the only currency to disconnect from the almighty dollar (Chart 1). Last but not the least, interest rate differentials between the US and China, after the rally on US treasuries, also call for a weaker RMB (Chart 2). 
• All in all, the RMB is not likely to be an exception among the weakening EM currencies. Instead of staying with the USD, the RMB will be more likely to follow the other EM currencies, and more generally, to stabilize its value against the trading partners (stabilizing CEFTS). That said, the PBoC’s pragmatism will probably only allow the RMB to depreciate at a steady pace.

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