The RMB Struggle: Rising USD Demand and Tightening Liquidity

Shanghai at dusk

The Chinese yuan (RMB) is facing increasing challenges as USD demand in China surges while USD supply remains constrained. The People's Bank of China (PBoC) is stuck in a tricky balancing act, trying to stabilize the currency in the face of growing pressure from both domestic and external forces. Let’s break down the situation and explore what could happen next.

The Rising Demand for USD in China

The demand for USD in China has been climbing steadily, driven by several key factors:

• Imports: As China continues to import goods and services, companies need USD to settle those transactions. This is a natural source of USD demand.

• Investment Outflows: Chinese investors are increasingly seeking to move capital abroad, which requires buying USD to fund overseas investments.

• Services and Income Payments: China’s growing services deficit and the need to pay for things like overseas education, insurance, and tourism are also pushing up the demand for USD.

As the demand for USD increases, the supply of USD in China remains tight. Exporters, who traditionally help provide USD liquidity by converting their foreign earnings into RMB, have cut back on their FX sales. At the same time, the PBoC is keeping a tight grip on the currency market, restricting the overall supply of USD.

The Impact of the USD-RMB Imbalance

This growing imbalance between USD demand and USD supply is having several consequences:

• Capital Outflows: In September 2023, China saw record RMB outflows, totaling RMB325 billion (USD45 billion)—the highest monthly outflow on record. Many of these outflows are driven by individuals and companies moving money offshore to access better investment opportunities or to simply buy USD.

• Declining Onshore Trading Volume: As the USD-CNY exchange rate has been squeezed by the PBoC’s controls, onshore FX trading volumes have dropped dramatically—around 50% year-on-year. This signals that there is less natural FX supply in the onshore market, and demand is either being postponed or pushed into offshore markets.

• Pressure on FX Reserves: To meet the growing demand for USD, the PBoC has had to dip into its FX reserves, with monthly declines of up to USD45 billion in August and September 2023. This is unsustainable in the long term, as it drains reserves and increases the risk of financial instability.

PBoC’s Tightening FX Controls

To manage the growing USD demand and prevent the USD-CNY exchange rate from breaching the ±2% trading band (the ceiling set for daily fluctuations), the PBoC has implemented several measures:

• Offshore Funding Squeeze: The PBoC has been tightening liquidity in the offshore CNH market to keep the USD-CNY rate from reaching its ceiling. However, these measures are putting additional strain on onshore liquidity and raising concerns about the longer-term impacts on China’s economic growth.

• Selling USD Reserves: The PBoC has also been selling USD reserves to stabilize the RMB, but this puts further pressure on China’s foreign reserves, which are already under strain.

While these measures have kept the exchange rate under control for now, they come with trade-offs. The growing imbalance between USD demand and USD supply could worsen if these pressures continue, leading to more capital outflows, a tightening of liquidity, and potentially even a slowdown in economic growth.

What’s Next for the RMB?

The big question now is: What’s next for the RMB? There are a few possible scenarios:

1. The Impasse Continues: The PBoC could maintain its current strategy, keeping the USD-CNY exchange rate near the ceiling. However, this would likely continue to drain foreign reserves and exacerbate the liquidity squeeze, increasing the costs of this approach.

2. Widening the Trading Band: The PBoC could widen the trading band, giving the RMB more flexibility. But this might only shift the impasse to a new ceiling without addressing the underlying imbalance in FX demand and supply.

3. Raising the Fixing: If economic conditions worsen or the RMB becomes significantly overvalued, the PBoC could raise the fixing and the ceiling to give the currency more room to move.

4. Lowering the Spot Rate: The PBoC could intervene more aggressively to push the spot rate lower. But this would require a shift in some of the key drivers of RMB weakness, including more clarity around China’s economic policies and a dovish tilt from the U.S. Federal Reserve.

The Bottom Line

The RMB is currently at a crossroads, with rising USD demand and tightening liquidity creating significant pressure on the currency. The PBoC is working hard to maintain stability, but the trade-offs involved may become more costly over time.

How China handles this delicate situation—through adjustments to its monetary policy or foreign exchange controls—will play a critical role in determining the future path of the RMB.

Stay tuned, as the next few months could reveal whether the RMB can regain its footing or whether the current impasse will continue.