The RMB offers a yield advantage of 2.25% to 2.75% relative to the euro, pound and US dollar. Not only has this resulted in a higher relative return due to carry, but it provides a buffer in case the RMB suffers any modest depreciation in the short term.
Some investors are concerned that, as the US economic recovery continues and the Fed tapers its bond purchases, the carry trade could come under pressure. These prospects revive bad memories of the mid-2013 taper tantrum, in which US real interest rates rose sharply and triggered a strong dollar rally.
We believe that investors with RMB exposure should stay the course. The 2013 playbook is unlikely to be replayed in 2021. The Fed’s commitment to supporting fiscal policy and not acting pre-emptively against potential inflation has been well telegraphed. We can expect both US real and nominal yields to rise, but the extent and pace will likely be much less disruptive than in 2013.
Long-Term Policy Goals Lend Short-Term Support
Recent moves by China’s central bank have been perceived as another policy risk. Since the second-quarter rally, the PBOC has taken steps to contain the RMB’s rise, including a directive to financial institutions to increase their foreign-currency holdings. This limits banks’ scope to deal in foreign exchange and influence exchange rates.
But such initiatives are aimed primarily at taking the speculative heat out of the currency. China’s broader policy measures remain supportive of further RMB appreciation, in the short term as well as longer-term. For example, the opening of China’s capital markets, while a long-term strategy, is likely to be supportive for the RMB in 2021 and 2022.
Chinese bond and equity markets have benefited from foreign portfolio inflows, as investors rebalance their funds to match benchmarks that now include significant allocations to Chinese securities. In the case of the bond market, these flows will rise again in late 2021 as Chinese Government Bonds (CGBs) enter the widely followed FTSE World Government Bond Index.
Index changes aside, CGBs are likely to appeal to foreign investors because their nominal and real (inflation-adjusted) yields are so much higher than those of other large bond markets. Five-year real, or inflation-adjusted, CGB yields are 2.0% compared to –1.50% for US Treasuries and –1.70% for the German Bund.
Recent PBOC guidance indicates that real CGB yields will remain positive and attractive into 2022, adding a measure of inflation protection to the attributes helping make the RMB attractive to offshore investors.
It’s not just bond and equity markets that China is keen to open up. In late May, the PBOC and the State Administration of Foreign Exchange announced an increase in the debt limit for locally incorporated foreign banks. These changes should support foreign banks’ China operations and lead to stronger capital flows into China.
At the end of 2020, the onshore assets of the 41 foreign commercial banks in China accounted for 1.2% of the system’s total assets. There is plenty of room for growth.
FX-Rich Exporters May Bolster RMB Demand
A potential new source of short-term support for the RMB comes from China’s exporters, who have contributed strongly to the country’s economic recovery in 2020 and 2021. The amount of foreign currency (mainly US dollars) sitting in domestic deposits now exceeds US$1 trillion for the first time (Display).
