Goldman Confirms China's New FX Index Signals Further Yuan Devaluation To Continue

Confirming what we explained here, Goldman Sachs notes that the publication of a new CNY exchange rate index suggests an increased focus on broader CNY moves against other non-USDollar currencies and reinforces the likelihood of further depreciation versus the USD.

Goldman Sachs writes...

The China Foreign Exchange Trade System (also known as CFETS), a sub-institution of the People's Bank of China whose main function is organizing the inter-bank FX market, published a new CNY exchange rate index on its website on December 11th. The stated intention of the new index is to help bring about a shift in how the public and the market observe RMB exchange rate movements--emphasizing broader (trade-weighted) currency moves rather than simply bilateral moves versus the US dollar. The PBOC re-posted the CFETS announcement on its own website. In our view, this reinforces the likelihood of moderate depreciation versus the USD, should the broad USD continue to strengthen per our forecast.

The new index references 13 currencies, with their weights reportedly based on the countries' importance for China's trade, after adjusting for re-exports. Compared to BIS's China effective exchange rate index, which has previously often been referred to in official communications, weights assigned to the USD and EUR are noticeably higher (Exhibit 1)--the total effective weight assigned to the most major currencies (USD, EUR, JPY and GBP, including weight to the HKD in that of USD) is about 73%, compared to 54% in the BIS index. Note that CFETS mentioned yesterday that it would also start publishing CNY exchange rates based on the BIS basket and the SDR basket.

Since the decision by the IMF Executive Board to include the RMB in the Special Drawing Rights Basket on November 30, the authorities have more clearly allowed a weakening of the currency. The depreciation also followed the recent rise in the euro (vs. USD) in light of the less dovish than expected ECB move on Dec 3rd--this development caused the RMB TWI to ease on the margin, and all else being equal, might help mitigate the market sell-off pressure on the currency. Nevertheless, the recent rise in onshore CNY trading volume and widening of the CNH-CNY gap suggests that FX outflow might have picked up (Exhibit 2), likely reflecting increased expectation of RMB depreciation against the dollar as the weakening trend became visible.

Looking ahead, the news does not necessarily mean the PBOC will now peg the RMB on this basket. In recent days, the RMB depreciated not only against the USD, but indeed by even more against this CFETS basket (by 1.3% since Dec 3rd, by our calculation; Exhibit 3).

It remains to be seen whether the PBOC may decide to explicitly adopt this basket at some point in the future. In any case, however, in our view, the fact that the authorities have increasingly drawn public focus to RMB's performance on TWI basis rather than simply against USD reinforces the likelihood of moderate depreciation versus the USD, should the broad USD continue to strengthen per our forecast. This communication appears to signal the authorities' intention to maintain broad CNY stability in TWI terms, and may also make it easier for the authorities to offset USD strength without causing a major increase in policy uncertainty or expectations of a sharp one-off devaluation ahead.

Taken in conjunction with our global currency views, our baseline forecast of USDCNY at 6.60 on a one-year horizon implies a small (roughly 2.4%) appreciation of the CNY vs. the new basket over the coming year.

*  *   *

Of course, as we noted previously, the real purpose of the PBOC's exercise in FX management today was, just like in August, to fire a warning shot at the Fed's rate-hiking plans. Only this time the warning shot is far, far louder.


In September the Fed postponed its rate hike as a result of China's devaluation. Will it do the same again next week? Because if China is about to unleash a 15% deval of the CNY against the entire world, expect a flood of Chinese FX reserves as the PBOC tries to control the glidepath of its currency, and avoid an all out collapse driven by soaring capital outflows.

In other words, we are now right back where we were in mid-August, just before the bottom fell out of the market.