The Renminbi: Short-term Trading Risks and Long Term Trends

Since the August 2015 exchange rate reform,which effectively devalued the renminbi,the market has been alert to the currency's short-term risks. Short-term volatility was heightened after the People's Bank of China rolled out its formula for setting the daily parity rate,which guides trading,using the previous day's closing price plus a mid-rate against a basket of currencies. At the same time,expectations for the renminbi's longer term trend vary considerably. So why is it that authorities repeatedly state that there are no fundamental factors that dictate a depreciation of the renminbi -- yet investors continue to see weakness ahead? In fact,they are looking at exchange rate trends from completely different angles. The exchange rate reflects complex variables; on the one hand,it is a relative price for a commodity determined by economic fundamentals,while on the other hand it is an asset price affected by capital flows.

Foreign Exchange Market Structure

Before explaining exchange rate trend,let's first take a look at the structure of China's foreign exchange market. There are two key features to China's domestic foreign exchange market: one is that it is restricted by the principle of real needs -- that a foreign exchange transaction must have a basis in real foreign trade business. The other is that there are a limited number of trading parties in the market. China's foreign exchange market is a closed market which takes interbank trading as its core,with banks and other financial institutions as the key players.

Under this structure,the renminbi exchange rate is heavily dependent on the trade surplus,because trade-related entities are the main source of supply and demand.  China's capital account has not been fully opened,so supply and demand from the capital market is not fully reflected in foreign exchange market trading.

Long-term Appreciation

Between 2005 and 2013,China maintained a trade surplus,and the foreign exchange market had an oversupply of dollars,resulting in a fairly steady appreciation of the renminbi.  It also meant that the central bank was consistently a net purchaser of foreign exchange and there was a steady increase in the nation's foreign exchange reserves.

This kind of structure in China's foreign exchange market helped avoid financial risks,but it also interfered with the price discovery function of the foreign exchange market. Since all transactions are supposed to be based on actual demand,there are few speculators or participants with a high-risk appetite. That can make the market appear one dimensional.

Foreign trade is the most important fundamental factor affecting the exchange rate,and cross-border trade partly reflects the extent of household savings over an extended period of time. Let us examine China's trade record to see if there is room for appreciation over the long term.

China continues to expand its share of world trade and its exports are showing further gains in competitiveness. Since 2000,China's exports have been increasing as a proportion of global trade. As of 2015,China's exports accounted for 13% of global trade,exceeding the combined market share of Japan and Germany. This shows that the recent year-on-year declines in China's exports were mainly due to a slowdown in overall global demand,and not a result of some other factor such as the renminbi exchange rate.  It also suggests that the competitiveness of domestic exporters has been improving.

From the 1970s through the 1990s,as Japan and Germany increased their share of global trade,the yen and the German mark also showed fairly steady appreciation. Now that China accounts for the biggest share in global trade,there is no reason for the country to use currency depreciation as a tool to take additional market share from other countries. Moreover,this suggests that there is still room for renminbi appreciation.

Moreover,the proportion of high value-added trade has surpassed the processing trade,long a key driver of China's exports. Since 2010,the growth in China's exports as a proportion of total global trade has been significantly higher than that of its imports. This is partly because China's exports are shifting towards higher value- added goods. Low-end transactions which depend on imports of materials for processing and have a significantly weaker capacity for earning foreign exchange,are gradually being shifted to other emerging market countries. In 2010,for the first time,the proportion of China's general exports exceeded exports from the processing trade.

A decline in imports is partly due to lower commodities prices but it also reflects the fact that more of the export supply chain is within China. The proportion of exports using imported processing materials has declined to 35% from 55% over this period,and this means there is a reduced reliance on imports. As a result,the export trade has a greater capacity to e