USDCNH Hits Yearly High: Property and Domestic Demand Hold the Key

Currently, amid mixed signals from US economic data and the Fed’s uncertain stance on rate cuts, the question arises: What factors underpin the CNH weakness? What are the primary challenges confronting the Chinese economy?

Additionally, while the PBoC refrained from adjusting the 1-year MLF and the 3-year and 5-year LPR this week, is future monetary easing still warranted? What policy shifts might be gleaned from the Lujiazui Forum?

China's economy continues the "two-speed" growth model

China's May activity data indicates a two-speed economy. Industrial production and fixed asset investment both fell short. Specifically, property investment remained weak, dropping 11% YoY, while infrastructure investment growth slowed to 4% YoY from 6% in April. 

On the flip side, retail sales and exports exceeded expectations. May exports saw a surprisingly strong 7.6% YoY growth, 6% higher than the previous figure. Although CPI was slightly lower than expected, with the MoM growth of -0.1%, PPI saw a monthly increase turning positive for the first time since last November.

Overall, China's economic growth continues to exhibit disparities. Capital expenditures in exports and new energy are the primary drivers, while consumption and the property sector are acting as drags. Supply remains robust, but demand, particularly domestic demand, is sluggish.

Simultaneously, the yield on China's 10-year government bonds has been on a downward trend since 2021, currently hovering around a relatively low level of 2.25%. The persistent strong demand for government bonds suggests that consumer confidence in the economic outlook still needs improvement.

The property sector is my main concern. Despite policymakers introducing the housing re-lending program a month ago, essentially making local governments the main buyers of property developers, the market remains unconvinced. New home sales in 30 major cities dropped by 35% YoY while existing home prices and new housing starts decreased annually.

However, there's a bright spot: bank loans to developers grew by 19%, the highest monthly growth since July 2020.

In summary, China's economy showed a moderate recovery in May, yet it still has a considerable distance to achieve full recovery. The "two-speed" growth model remains effective in sustaining economic development, primarily driven by strong performances in exports and the new energy sector. Nevertheless, the pressing issue that needs to be addressed is still the property industry.

PBoC is in no hurry to strengthen stimulus policies

This week, the People's Bank of China (PBoC) opted not to adjust the 1-year MLF or the 3-year and 5-year LPR rates, sparking speculation about its approach to managing CNY (CNH) exchange rates. While eventual action seems inevitable, the timing doesn't appear ripe.

One compelling reason for potentially needing more stimulus measures is the lingering vulnerability of China's property sector. Despite the re-lending initiatives rolled out on May 17th, which aimed to bolster property developers with local government support, there has been little traction among homebuyers. 

New home sales stagnated in May, and prices for existing homes remained flat. The RMB500 billion re-lending program (0.4% of GDP) seems inadequate in scale, given the significant fiscal strains faced by local authorities. To effectively implement these plans, further interest rate cuts or increased bond issuance may be necessary.

However, the Fed has yet to initiate rate cuts, and President Xi's call for the Yuan to be a “powerful currency” has influenced the PBoC's cautious approach. Despite ongoing deflationary pressures, the PBoC has refrained from cutting rates for ten consecutive months, citing concerns about exchange rate stability. 

At Wednesday's Lujiazui Forum, PBoC Governor Pan Gongsheng hinted that the primary constraint on monetary policy remains the Fed. He suggested that once the Fed begins easing later this year, the PBoC will have greater flexibility to adjust its policies.

From an urgency perspective, I believe the PBoC has room to buffer before implementing the next rate cut. Looking back to early May (circled in the chart), CNHCNY (blue line) briefly spiked near 1.006, while simultaneously USDCNH (orange line) saw a notable downward correction. 

This occurred because when the market anticipates a unilateral movement of CNY against USD, they tend to hold CNH, which has greater volatility, to maximize profits.

However, the recent stability of CNHCNY suggests that the market is not heavily betting on a rapid increase in USDCNH in the short term. This remains an acceptable outcome for the PBoC.

Furthermore, since late April, the yield spread between U.S. and Chinese 10-year government bonds has generally narrowed. This has reduced the incentive for people to sell CNY (CNH) and buy USD, thereby helping to alleviate capital outflow pressures.

In addition to potential across-the-board rate cuts, the PBoC could leverage its unique tools like the Pledged Supplementary Lending (PSL) to selectively reduce rates for policy banks. In December last year, the PBoC injected 350 billion RMB into housing and infrastructure projects through the PSL, effectively stimulating economic growth similar to measures taken in 2018.

In conclusion, the relative weakness of CNH may persist until the Fed adjusts its interest rate policy or signals a shift, making the "red line" of 7.28 a crucial reference point. Also, there is limited urgency for the PBoC to pursue further interest rate cuts.

Chinese monetary authorities may adjust the policy framework

Beyond discussions on potential fixings to the CNY (CNH) influenced by the Fed's interest rate stance, another key takeaway from Governor Pan's speech was the possible reshaping of the PBoC's future monetary policy framework.

Instead of maintaining the current two-policy-rate system—DR007 (7-day reverse repo rate) and the MLF rate—there's a possibility that only the DR007 rate will serve as the sole signal going forward. Governor Pan also floated ideas about narrowing the interest rate corridor and conducting secondary market bond trading through open market operations. 

These moves aim to provide clearer signals for monetary policy decisions and stabilize the domestic economic environment.

Overall, boosting consumer confidence remains a top priority amid current challenges in the property sector and domestic demand segments. While keeping USDCNH at elevated levels in the short term may be unavoidable, with the Federal Reserve entering an easing cycle, Chinese authorities could have more flexibility for interest rate adjustments. 

Coupled with the potential introduction of a new round of PSL and optimization of the monetary policy framework, CNY (CNH) could see a return to a balanced state.