The dollar’s volatility has intensified as the Federal Reserve continues to signal monetary tightening. After hitting an intraday high of 96.91 in mid-December 2021, the U.S. Dollar Index began to fluctuate downward, bottoming out at 94.63 on January 13, depreciating by 0.86% in less than a month. On January 14, the U.S. Dollar Index rose 0.39% and closed at 95.1673 after falling below 95 in previous days. In this context, the RMB exchange rate performed strongly and appreciated rapidly again. With the weakening of the central parity rate, the onshore USD/RMB exchange rate even broke through 6.36 and reached the level of 6.352 on January 14. The continual fluctuation of the U.S. dollar in the post-pandemic period, as well as its impact on the RMB exchange rate, are posing accumulated external risks for the world and China.
In theory, the Fed’s “sharp turn” policy should lead to a stronger dollar, and a faster pace of Fed tapering would mean higher bond yields, thus pushing the dollar to a stronger appreciation. In terms of international markets, this will bring a tendency for capital to flow back to the U.S., while emerging markets would face a “taper tantrum”. However, we have seen the opposite in the dollar’s recent trend, showing a tendency towards depreciation starting in December 2021. This indicates that the volatility risk of the U.S. dollar is not as expected, and various factors lead to more uncertain short-term fluctuations of the U.S. dollar.
The dollar’s weakness is seen as being driven not only by a weaker U.S. economy but also by a change in expectations. Continued high inflation in the U.S. is not only “diluting” the value of the dollar, but also dragging down the recovery of the U.S. economy. Retail sales fell 1.9% month-on-month in December last year, the biggest drop in 10 months, far worse than economists’ expectations of a flat reading. Manufacturing output fell 0.3% in December, well below economists’ expectations for a 0.3% rise. The University of Michigan’s consumer sentiment index fell to 68.8 in January from 70.6 in December, the second-worst reading in a decade and worse than the median forecast of 70 by economists. These are signs that U.S. economic growth is less than expected amid the new outbreak of the omicron virus. As a result of the pandemic and inflation, some international institutions and major institutions in the U.S. have lowered their economic growth forecasts for the U.S. this year. The World Bank’s latest report predicts that the U.S. economy will grow by 5.6% in 2021, down 1.2 percentage points from its previous forecast; economic growth in 2022 is expected to be 3.7%, down 0.5 percentage points. Moody’s expects U.S. GDP to grow 3.4% in 2022.
At the same time, although the Fed announced that it would tighten the pace of easing, it did not stop quantitative easing until March 2021, resulting in increasing dollar liquidity. These circumstances caused the dollar to begin to depreciate in the short term. Last year, the dollar actually started to strengthen in the second half of 2021, rising from a low of 89.64 in late May to a high in mid-December amid optimism about the U.S. economy and expectations of a Fed tightening. In the process, the market is effectively pricing in expectations of a Fed tightening and the optimistic expectations of U.S. economic growth. Rising inflation and falling treasury yields are also weighing on the dollar index. In other words, the current change means that inflation and the pandemic are back as major factors influencing the dollar.
ANBOUND has previously noted the increased volatility and accelerated cycle of the U.S. dollar in the post-pandemic period. In regard to the RMB exchange rate, this will continue to affect the stability of China’s economy and its financial markets. In particular, from the second half of 2021, the RMB exchange rate continued to appreciate against the U.S. dollar despite the continued strengthening of the U.S. dollar. This did not abate significantly after the Fed stated it would tighten monetary policy at a faster pace while the People’s Bank of China (PBoC) raised foreign exchange reserve requirements. Recently, while the dollar has depreciated, the RMB has shown further appreciation. This will create increasing uncertainty for the Chinese economy. A stronger RMB would put even more pressure on China’s commodity exports. While China’s foreign trade has grown markedly over the past year despite distortions in global supply chains, the latest data show a slowing trend in export growth. The continuous appreciation of the RMB does not actually mean more gains for enterprises, but rather more losses in foreign exchange. The obvious appreciation of the RMB in the short term means that the pressure on foreign exports will be greater, and will even affect a considerable number of small and medium-sized enterprises, thus impacting the supply chain.
Over the past year, China’s relatively stable economy has continuously attracted international capital inflows into its capital market. However, if the Fed decides to cease its quantitative easing at the end of March and raise interest rates, the RMB’s long-term trend of appreciation will revert to a long-term trend of depreciation as interest rate differentials between the U.S. and China narrow. In this case, the greater the current appreciation, the greater the future adjustment will be. Moreover, it also means that possible cross-border capital flows in the future will bring more uncertainty to the stability of China’s financial markets. In fact, for China and other emerging markets, the long-term trend of dollar appreciation is very powerful and harmful. The dangers of this “taper tantrum” will gradually emerge in the future, bringing more instability to the RMB exchange rate.
Although PBoC has made exchange rate stability one of its monetary policy goals, the increased volatility of the U.S. dollar will have a direct or indirect impact on China’s economy. A rapid depreciation or appreciation of the exchange rate would be detrimental to China. Researchers at ANBOUND have mentioned that the stability of the RMB exchange rate is like a firewall for China’s economy and financial markets, which is extremely important for China’s “stable growth”. At present, the fluctuation of the U.S. dollar has become a disturbing factor affecting China’s economic stability. On the one hand, because of the perplexity of the dollar, it is vital for China to improve its market education, guide firms to stick to the RMB’s neutral expectation and build a risk hedging mechanism. On the other hand, supervision over cross-border capital flows should be strengthened to avoid the impact of excessive capital flows. Of course, China’s monetary policy needs to be forward-looking in terms of RMB liquidity and adopt a flexible and precise approach to moderately increase or decrease the supply of RMB to stabilize the RMB exchange rate.
Final analysis conclusion:
Sustaining the RMB exchange rate’s stability is tantamount to maintaining China’s domestic market and financial environment. This in turn, is a vital foundation for maintaining the country’s economic stability and growth in the face of rising volatility of the U.S. dollar and the Fed’s “sharp turn” strategy.