Recently, the Chinese Yuan (RMB) has faced increasing pressure against the US Dollar, hitting a low of 7.0171 in offshore trading on September 15. Meanwhile, the onshore exchange rate breached the critical level of 6.99, bringing it ever closer to the symbolic "7" benchmark.

Looking ahead, the primary determinants of short-term exchange rate fluctuations will hinge on energy prices and whether the ailing Chinese real estate sector shows any signs of recoveryIn a fourth quarter marked by a situation in Europe and the United States where the economic fundamentals aren't significantly improving, a potential upward movement in the US Dollar index could passively affect the RMB exchange rate

Nevertheless, it is believed that the People's Bank of China (PBOC) has a strong resolve to maintain stability in the currency exchange rates, and that a break of "7" would have minimal impact on the Chinese economy and capital markets, rendering excessive concern unnecessary.

The depreciation of the RMB is a somewhat expected phenomenon

However, the "reasons" have slightly exceeded expectations

Since the beginning of this year, the RMB exchange rate index from the China Foreign Exchange Trade System (CFETS) has shown a relatively weak trend, characterized by periodic fluctuations

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After mid-July, amid a backdrop of a strong US Dollar and a weakening RMB, the RMB index saw a backslideNotably, the RMB depreciated by 1.87% against the Euro, 1.56% against the Japanese Yen, and 2.52% against the Canadian Dollar

Correspondingly, the US Dollar index has retained a strong performance, rising by 1.7% since mid-July, while the Dollar has appreciated by 1.5% against the Euro and 3.0% against the British Pound.

Various factors contribute to the depreciation of the RMBThe primary contributor has been the real estate sector; amid ongoing risks, policy interest rates such as the Medium-term Lending Facility (MLF) have been unexpectedly lowered, and the Loan Prime Rate (LPR) has also been cutThese steps reflect the market's sustained pessimistic expectations for the future, leading to a renewed sensitivity of the exchange rate towards nominal interest differential compared to last year

In stark contrast, the Federal Reserve's hawkish stance on monetary policy and its accelerating pace of interest rate hikes have contributed to continual appreciation of the Dollar against the RMB.

Furthermore, under an adverse economic outlook, capital outflows have become a significant "accelerating force" for RMB depreciationWith new COVID-19 cases appearing again across multiple locations in China, the stronger pessimism surrounding future expectations compared to the real economy renders capital outflow pressures even more salientData indicates a rapid decline in the scale of direct and portfolio investments in the financial account, with direct investment decreasing from $59.9 billion in the first quarter to just $15 billion in the second quarterSimilarly, securities investment saw a stark fall to -79.756 billion Yuan in Q1, indicating a weak seasonal performance; on one hand, there has been a massive net outflow from the A-share market amidst decreased risk appetite; on the other hand, differentiation in monetary policies between China and the US has placed significant pressure on the bond market, further exacerbating the RMB's fragility.

Though exports have surprisingly propped up the RMB from the currency settlement perspective, overall, the influences of securities investment, direct investment, the yield differential between China and the US, and depressed real estate investments continue to diminish the support for the RMB exchange rate compared to last year.

The impact of "breaking 7" on capital markets is limited

A further surge in the US Dollar index could impose constraints

Going forward, the short-term outlook for RMB depreciation appears to be improving slightly, with medium-term trade surpluses still providing some support

Nonetheless, the core trajectory of the current exchange rate remains heavily influenced by energy prices and whether the real estate outlook can effectively recover.

First, while the current depreciation of the RMB is visible, it is generally manageableOn one hand, from a long-term interest rate perspective, expectations of RMB depreciation have intensified but remain relatively limited.

The one-year Non-Deliverable Forward (NDF) exchange rate, traded in the offshore market, serves as a gauge for overseas expectations of RMB appreciation or depreciationSince the beginning of the year, it has notably rebounded, driving the CFETS RMB index lowerSince July, the one-year NDF has risen from 6.68 to the current level of 6.89, indicating that while pressure exists for depreciation, it has not soared dramatically

Moreover, the difference between the onshore and offshore USD/RMB spot rates has not significantly widened, suggesting that market expectations for RMB depreciation remain stable in the short term.

Secondly, the peak phase of capital outflows appears to have passedThe process of broad credit expansion continues, most notably reflected in the recent rise in bill rates due to pandemic-induced disturbances, indicating a weak recovery is still ongoingStock Connect saw cumulative net purchases in August, and during this period, foreign investors overall increased their net purchases of Chinese securities, mitigating the negative impacts of capital outflows on the RMB exchange rate.

Lastly, a substantial trade surplus continues to offer support for the RMB exchange rate

Although the trend of declining exports seems set to persist—evidenced by South Korea's exports plummeting from 14.2% to 3.9%—signals of weakening global trade demand are emergingPrice-related metrics for exports are similarly on the decline, with the China Containerized Freight Index (CCFI) and the Shanghai Containerized Freight Index (SCFI) experiencing rapid reductionsHowever, we believe that the probability of a higher trade surplus is significant in the second half of the year, with currency settlement demands not fully released, thereby potentially reinforcing the RMB exchange rate.

We assert that attention should be paid to the passive depreciation of the RMB resulting from a rising US Dollar index this yearNotably, the ongoing expectations of a European recession continue to fuel upward momentum in the Dollar index

Escalating conflicts and high natural gas prices imply that inflation in the Eurozone is likely to remain elevated for the foreseeable future, with the anticipation of a Eurozone recession likely contributing to further depreciation of the Euro, further bolstering upward pressure on the Dollar.

Moreover, the interplay between stagnant inflation and recession in the US remains of heightened sensitivity for capital marketsWhile the Federal Reserve continues to enact aggressive interest rate hikes, July's US Consumer Price Index (CPI) slightly retraced from a peak of 9.1% to 8.5%. However, how inflation trends shape up moving forward remains uncertain, with energy and food price stabilization potentially on the horizon only after an economic slowdownSmall, slightly better-than-expected data may drive the markets to adjust expectations rapidly regarding interest rate hikes, influencing US Treasury yields and bolstering the Dollar index

On the contrary, while fundamental trends indicate a slowdown for the US economy, sporadic signs of recovery in certain metrics could still put pressure on the RMB.

Furthermore, the rate of recovery in the real estate sector will also impact interest rates, thereby influencing the exchange rateHistorically, periods of renewed activity in China's real estate market—typically indicated by increases in the sale of new housing—have coincided with rising yields on 10-year government bondsRecently, the central bank has opted to cut the five-year LPR again to stabilize real estate and support the economyIf the slope of recovery in the second half of the year is robust, it could inject confidence in the economy, propelling long-term interest rates upwards, thus reducing the differential between China and the US, offering support for the RMB exchange rate