Investment Research — General Market Conditions
7 January 2016
FX Strategy
CNY outlook: more weakness ahead
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
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The CNY has weakened considerably against the USD over the past month and
the move accelerated this week. It followed equity turmoil and confusion over a
fixing by the People’s Bank of China (PBoC) that was weaker than its new
regime should warrant.
In this document we look at what is driving Chinese FX policy and what guide
posts to look for in determining where the CNY is heading. We have revised higher
our USD/CNY forecast, looking for a bigger weakening of the CNY over the next
year to 7.0 versus the USD – a further depreciation of 7% over 12 months. We look
for a weakening against the EUR of around 15% over the next year.
We continue to recommend corporates hedge receivables in CNY via the CNH
market. The CNH-CNY spread should narrow in 12M from very wide levels.
Five key takeaways from the past years CNY changes
New CNY/CNH forecasts
USD/CNY
06-Jan
+3M
+6M
+12M
Danske
6.56
6.70
6.85
7.00
EUR/CNY
Forward
6.74
6.83
6.93
USD/CNH
Danske
7.05
7.10
7.54
8.12
Spread CNH-CNY
Forward
Danske
06-Jan
6.70
6.70
6.700
+3M
6.83
6.78
0.13
0.05
+6M
6.95
6.84
0.10
0.02
+12M
7.05
6.93
0.05
0.00
Note: CNY forward is NDF
Source: Danske Bank. Bloomberg
1. CNY has become more market based – but is still a managed currency.
2. China now manages explicitly against a basket – and not the USD.
3. China states officially that the CNY (trade weighted) is at the ‘equilibrium level’.
4. China allows continued depreciation versus the USD as long as the trade-weighted
CNY is around the so-called ‘equilibrium level’.
5. The CNH-CNY spread is likely to stay wide short term but narrow over time.
More market based CNY but still managed against a basket (trade weighted CNY)
Important disclosures and certifications are contained from page 6 of this report.
7.26
7.38
7.55
Danske
A lot of action and changes to the Chinese foreign exchange system took place in 2015,
which has set a new course for the Chinese currency. Understanding the new policy and the
implications is still a learning process as witnessed this week. However, the following are
some of the factors to take into account from the developments over the past year.
Source: Macrobond Financial, Danske Bank
Forward
Chief Analyst
Allan von Mehren
+45 45 12 80 55
[email protected]
www.danskeresearch.com
Forward
FX Strategy
Ad 1. CNY has become more market based – but still managed
On 11 August, China took a further decisive step towards a more market-based
currency as the daily reference rate became based on the market spot rate and is no longer
set discretionarily by the PBoC (see Box 1 in the Appendix). This follows other steps in the
past five years, where China has taken measures pulling in this direction: continued
financial liberalisation and internationalisation of the CNY and a widening of the daily
trading band. The so-called ‘impossible trinity’ illustrates that a country cannot have free
capital movements, independent monetary policy and a fixed exchange rate. It can have
only two of the three. As China opens up and wants an independent monetary policy, we
believe an unavoidable effect of this is that it will be more difficult for China to manage its
currency.
Markets have pushed the CNY weaker
vs the USD after the change in fixing
Source: Macrobond Financial
While the CNY is becoming more market based, it is not likely to be a completely free
floating currency for several years – maybe ever. In the same statement mentioned above,
China describes its exchange rate system as ‘a managed floating exchange rate regime’.
China believes that it serves its interest best to avoid too big swings in the currency as
big changes can become disruptive. Almost everything China has done since market
reforms started in the late 1970s has involved gradualism. The experience from the 30 years
under Chairman Mao was that ‘big leaps’ and rapid changes in policy caused severe
disruptions in the economy. Since then China has governed by gradualism (‘crossing the
river by feeling the stones’). It wants to hold on to a certain amount of control and thus
continues to have a policy of managing the currency to avoid disruptive moves.
Chinese intervention has led to a
decline in currency reserves
Bn, USD
4,500
4,500
4,000
4,000
3,500
3,500
3,000
3,000
Adjusted China FX reserves*
2,500
Due to the impossible trinity it is becoming increasingly difficult to manage the
currency as witnessed by the recent sharp weakening versus the USD. However, China
still has tools to manage the CNY to some extent: First, it does not yet have completely free
capital movements and would probably not hesitate to use higher capital control as a
measure if it sees fit to halt outflows. A ‘tax’ on selling CNY onshore in the forward market
introduced last year is an illustration of this. Second, China still has a significant currency
reserve of close to USD3.5trn (around one-third of Chinese GDP) that it uses to stem
depreciation pressure. From when the outflows intensified after the reform on 11 August
until November, China sold FX reserves of close to USD200bn to support the CNY and
dampen the pace of depreciation.
On Wednesday 6 January, a fixing for USD/CNY was set higher than the closing level
the day before in contrast with the new fixing regime, which has set off confusion and
speculation of a deliberate weakening of the CNY. However, this would make no sense as
reports were made that China was at the same time intervening to support the CNY on
Tuesday 5 January. The reference rate is actually based on reports from market makers to
CFETS and these reports may not have reflected the closing level fully. The confusion
could stem from China having extended the opening hours for CNY but still saying that the
reports from market makers should reflect the level at the old closing time of 16:30 Beijing
time. Some market makers may not have followed this. However, it is unclear whether this
is what has happened. If so, it should be corrected but time will tell.
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China FX reserves
2,000
Note: Adjusted reserves adjusted for valuation
effects from change in exchange rates
Source: Macrobond Financial, Danske Bank
The impossible trinity
Source: Danske Bank
www.danskeresearch.com
2,500
2,000
FX Strategy
Ad 2. CNY managed against basket of currencies – not the USD
Another important change in China has been the move towards a system that manages
against a basket of currencies – rather than just the USD. This was made explicit in a
press release on 11 December 2015 (see Box 2 in the Appendix). The policy of managing
against a basket of currencies goes a long way to explaining why China is letting the CNY
weaken so much versus the USD. The trade-weighted CNY is still only around the level
seen this summer when China said the CNY was at the equilibrium rate. This is because the
USD has strengthened against other currencies as well and, therefore, the CNY is only
weakening moderately when evaluated against the basket of currencies.
The system of managing against a basket has arrived gradually after close to 10 years
of a policy of appreciation against the USD (with only a short pause during the financial
crisis). The weakening of the CNY against the USD since 2014 has been an attempt to
mitigate the effects of the sharp appreciation of the USD on the CNY. Nevertheless, it
caused the trade-weighted CNY to strengthen by 10% from the beginning of 2014 to today.
Trade weighted CNY not weaker than
at the start of the 2015
Source: Macrobond Financial
Ad 3 and 4. CNY (trade weighted) at ‘equilibrium level’
After years of strong appreciation of the trade-weighted CNY, China now sees the
currency at the ‘equilibrium rate’. This has been stated in pretty much all statements and
speeches by the PBoC and the Chinese leadership when mentioning the CNY since 11
August when they changed the fixing system. However, if the currency is at the equilibrium
level, how come China lets it weaken so much against the USD without stronger
intervention than it seems to do? It is because China evaluates the strength of its
currency on the back of the trade-weighted CNY index and not just the USD. This is
what it seemed to want to stress on 11 December when it published the CFETS tradeweighted index with weights for all currencies in the basket (see Box 2 in Appendix). As
mentioned on a trade-weighted basis, the CNY has not weakened that much and is still
around the level seen this summer. However, the market is likely to test it on this in coming
months.
The continued emphasis that the currency is at the equilibrium rate does not indicate
that China sees a much weaker currency as part of the strategy to give support to the
economy. China seems to prefer other measures such as a moderate easing of credit, lower
interest rates and measures to get rid of the inventory in the housing market. China is also
highlighting innovation and reforms of State-Owned Enterprises (SOEs) An article in the
government-controlled China Daily LINK recently highlighted that China looks to supplyside reforms relative to Keynesian demand stimulus to support growth a la the big stimulus
package in 2009. Nevertheless, we expect further interest rate cuts ahead, which would
continue to push for a weaker CNY against the USD as the Fed is now raising rates.
10 years appreciation against the USD
over – more weakening ahead
Source: Macrobond Financial
Even bigger depreciation expected
against the EUR
Weaker CNY ahead – receivables should be hedged
With market forces working very strongly for a weaker CNY, we expect China to
allow the trade-weighted currency to move lower by around 5% from the current level
over the next 12 months. Depreciation pressure continues to be in place from divergence in
monetary policy between the US and China and a general expectation that China actually
does not mind a weaker currency – equilibrium level or not. As the currency has become
more market based, the currency will increasingly go where the market is pushing it.
Source: Macrobond Financial
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FX Strategy
We expect the pressure to be the strongest over the next three to six months, when we
look for the USD to strengthen further versus the EUR. As we look for a turnaround in
EUR/USD later this year for a move higher, we expect the depreciation pressure on the
CNY to ease a bit – although still be in place. We have changed our forecast and now look
for more increase in the USD/CNY to 6.70, 6.85 and 7.00 on 3M, 6M and 12M horizons,
respectively – a total further depreciation of around 7%. Given our forecast for EUR/USD,
this implies a rather sharp weakening of the CNY against the EUR of 15% over the next
year (see the table on the front page).
Our forecasts for CNY are weaker than what is in the forward market and we
continue to recommend hedging CNY receivables as has been the case since the change
of the FX regime this summer.
Ad 5. CNH-CNY spread set to stay wide short term
It has proven more difficult than expected for China to keep the CNH-CNY spread
narrow. The spread is now at wider levels than after the immediate ‘panic’ following the
change in fixing system on 11 August. The wide spread illustrates two things.

First, it is a sign of significant market pressure for a weaker yuan. The CNH market
can be traded freely and pretty much all of the hedging and more speculative trading
by hedge funds is likely to be taking place in this market.

Second, it shows that it is very difficult for the PBoC to control this spread through
intervention. Reports of offshore intervention have been frequent over the past few
months and on Tuesday 5 January. However, despite this it has not been able to stop
the CNH-CNY spread from widening.
CNH-CNY expected spread to narrow
gradually
Source: Macrobond Financial
We expect the CNH-CNY spread to stay at wide levels in the short term, as the
strong pressure on the CNY remains. However, we look for a decline over time, as
we expect the depreciation pressure on the USD/CNY to ease a bit once we see a
turnaround in the EUR/USD, as this would make China less inclined to let the USD/CNY
rise. It was a specific demand from the IMF for China’s inclusion in the SDR that the
spread should be narrow and the current move is likely to be causing concern at the IMF
as well as for the PBoC.
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FX Strategy
Appendix: Documentation on changes in FX system
Box 1: China’s new FX system 2015
The following quotes are from China’s press release illustrating the new FX regime on
11 August.
‘Effective from 11 August 2015, the quotes of central parity that market makers report
to the CFETS daily before market opens should refer to the closing rate of the interbank
foreign exchange market on the previous day, in conjunction with demand and supply
condition in the foreign exchange market and exchange rate movements of the major
currencies.
China is implementing the managed floating exchange rate regime based on market
demand and supply. The fluctuation of exchange rates is a normal phenomenon, to
which, we should take an objective view. In the future, the PBoC will strive to further
improve market-based formation mechanism of RMB exchange rate, maintain a normal
fluctuation of RMB and keep the exchange rate basically stable at an adaptive and
equilibrium level.’
Source: People’s Bank of China
Box 2: The explicit move to managing against a basket rather than only USD
The following extract is from the PBoC’s press statement on trade weighted CNY on
11 December 2015.
‘For quite long, market participants have used bilateral exchange rate of RMB against
USD to assess RMB exchange rate movements. However, as fluctuations of exchange
rate serve to adjust trade and investment activities with multiple trading partners, the
bilateral RMB-USD exchange rate is not considered a good indicator of the
international parity of tradable goods. Therefore, it is more desirable to refer to both
the bilateral RMB-USD exchange rate and exchange rate based on a basket of
currencies...Compared with referring only to one currency, a basket of currencies can
better capture the competitiveness of a country's goods and services.’
Weights in the CFETS trade weighted currency
USD
EUR
JPY
HKD
GBP
AUD
NZD
SGD
CHF
CAD
MYR
RUB
THB
0.26
0.21
0.15
0.07
0.04
0.06
0.01
0.04
0.02
0.03
0.05
0.04
0.03
Source: People’s Bank of China
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Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske
Bank’). The author of the research report is Allan von Mehren, Chief Analyst.
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