The balance of risks in global bond and currency markets is shifting as economies recover unevenly from the pandemic. Investors reassessing their exposures should consider the diversification opportunity offered by the Chinese renminbi (RMB) and its positive long-term outlook.
A revival of long-dormant concerns about inflation, together with recent yield volatility in the US bond markets, is a timely reminder for fixed-income and currency investors to take a long-term view of risks and opportunities, and to diversify their portfolios appropriately.
Many, for example, would consider the recent rise in US yields as a potential opportunity, especially compared to Europe, where the European Central Bank has reaffirmed its commitment to keep interest rates low to help the regional economy pull through a third wave of COVID-19.
Fortunately, investors have more than one choice. China has already moved to normalize policy, creating, in our view, a powerful diversification opportunity in its currency and its bond markets.
RMB Internationalization Continues
Headlines about China during the last few years have focused mainly on the country’s trade tensions with the US and its handling of the COVID-19 crisis. They have largely obscured the progress the country has made with opening its capital markets to foreign investors and integrating its currency more deeply into the global economy.
As trade and pandemic difficulties have eased, attention has again turned to structural changes in the country’s financial markets.
The underlying driver of these changes is, of course, China’s economic growth. Most of the foreign capital supporting that growth is in US dollars, so it makes sense that China should want to diversify this exposure over time. Policymakers have launched initiatives to internationalize the RMB and make it another alternative to the US dollar as a store of global savings and a medium for transactions.
They have made considerable strides. In 2013, for example, China’s first free-trade zone opened in Shanghai; there are now 19. In 2015, the country launched the RMB-based Cross-Border Interbank Payment System (CIPS), a potential rival to the US’s Society for Worldwide Interbank Financial Telecommunications (SWIFT) system. CIPS has grown to include 160 countries—not far behind the 200 or so that use SWIFT—and has started making inroads on the US dollar’s dominance of global payments.
Cross-border settlements in RMB totalled RMB¥2 trillion in 2017; in the first quarter of 2020, they were more than RMB¥6 trillion (US$920 billion).
More recent initiatives include the launch of an annual forum to promote Shanghai as an international finance center, and the launch of an RMB-denominated copper market (China accounts for half of global copper usage). In 2020, China BaoWu Steel completed the first cross-border RMB settlement for iron ore with three global mining companies: BHP Billiton and Rio Tinto (both Anglo-Australian) and Brazil’s Vale.
Foreign-investment inflows attracted by the opening of China’s capital markets lend further support to the RMB. The country’s inclusion in global bond indices is growing: in October 2021, for example, it will gain admission to the FTSE World Government Bond Index. Full inclusion will take three years, by which time China will account for 5.25% of an index capitalized at around US$2.5 trillion.
While policy is helping to boost the RMB’s international acceptance, China’s economic development is important for the currency’s valuation prospects.
Productivity Growth Should Support RMB
Theory (and history) tells us that the currencies of countries that achieve faster productivity growth than their trading partners tend to appreciate over time. That was the case for Japan in its catchup growth phase from the 1960s. It has been the case for China as well. The real effective exchange rate (REER)—the inflation-adjusted RMB against a basket of trading partner currencies—has trended upward during the last 30 years (Display, blue line).
But how much should China’s REER have appreciated to account for the country’s relative productivity gains? Our analysis suggests that the gains in the REER have lagged productivity strength. The productivity-adjusted REER (Display, green line) has trended down over time. If REER appreciation perfectly offset the impact of productivity gains, then we would have observed no change over the period. In other words, the RMB appears to be undervalued: while the RMB has appreciated, the pace of appreciation hasn’t kept pace with its potential.
This implies that, should China’s relative productivity growth continue, the RMB should continue to appreciate, providing foreign-exchange gains for offshore investors. Recent policy developments suggest that China’s policymakers are indeed focused on further productivity gains for their economy.
At the annual National People’s Congress in March, the Chinese government confirmed the launch of a “dual circulation strategy” to rebalance the “domestic circulation” and “international circulation” aspects of the economy. The strategy involves diversifying further away from the traditional model of low-value exports and imported technology in favor of sourcing growth and innovation from the internal market.
Plans include an upgrade of the domestic manufacturing base, using information technology to improve productivity and increase the local content of high-end tech products. This attempt to move domestic industry up the value chain is similar to an attempt initiated by Singapore in 2010. Since then, the Singapore dollar has appreciated significantly in REER terms.
China’s RMB Goal: Strength and Stability
Over the near to medium term, additional foreign-investor inflows into China, an attractive yield compared to other large bond markets and a relatively hawkish central bank should support the RMB.
While there are risks to the outlook, they are moderate in our view. In the short term, perhaps the biggest cyclical risk is that China’s policymakers may prove overzealous in their attempts to deleverage the economy, thereby prematurely stifling the recovery in growth now under way.
Or perhaps tensions like those that characterized China-US relations under the Trump administration might arise under President Biden (China responded to tariffs imposed by President Trump in part by allowing the RMB to weaken).
It’s important to put these risks in perspective: while our long-term outlook for the RMB is positive, we don’t expect a steady, uninterrupted path of appreciation. We do, however, expect China to continue to pursue policies that are supportive for the currency.
Above all, China will want the RMB to be seen as stable and strong—characteristics that are essential to the currency’s continued international acceptance. They should also appeal, in our view, to investors looking for an attractive opportunity for long-term diversification.
Brad Gibson is Co-Head of Asia Pacific Fixed Income and Guy Bruten is Chief Economist—Asia-Pacific ex China at AllianceBernstein (AB).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.