The onshore yuan fell below 6.5, a weekly decline of more than 2%, the second largest decline since the exchange rate reform in August 2015.However, it is worth noting that on Friday (April 22, 2022), the Shanghai-Shenzhen-Hong Kong Stock Connect recorded a rare net inflow of 6.765 billion yuan in nearly a week, with the Shanghai Composite Index closing red. How to understand the performance of the exchange rate? It is also worth noting that Yi Gang, governor of the people's Bank of China, made it clear in his speech at the Boao Forum that "the primary task of China's monetary policy is to maintain price stability." How to understand the meaning of exchange rate and market behind this sentence?

We believe that the rare sharp devaluation of the RMB this week has both the impact of macro expectations.But perhaps more important is the significant decline in exchange rate market liquidity under the impact of the epidemic and the hidden dangers of trade credit that have magnified the impact. We still believe that the devaluation pressure of the RMB in the second quarter is on the high side, but such large fluctuations are not the norm.

Exchange rate depreciation is a double-edged sword, which helps exports on the one hand and may also lead to imported inflation on the other.In the context of rising commodity prices and the spread of the epidemic, the "inflationary effect" of devaluation is even greater. China will face an impossible triangle of exchange rate, inflation and stock market stability. Breaking the situation needs to control the epidemic as soon as possible or the central bank plays more role in stabilizing the exchange rate.

On the impact of macro expectations, the Fed continues to play the game of "snatching" with the market.Although we see signs of a slowdown in core CPI month-on-month in the us in march, what worries the fed is that market expectations for inflation are still rising, with 10-year inflation expectations standing at 3 per cent, at least a 20-year high.

In his speech on Friday, Powell basically confirmed that he would raise interest rates in May (50bp) and was open to future interest rate increases of the same magnitude.Affected by this, the market has begun to expect the Fed to raise interest rates by 50bp in May, June and July, respectively.We believe that under the "rush-off" strategy, the Fed's path of raising interest rates will show the characteristics of "steep in front and flat after", and the second quarter is the most extreme stage of the difference in expectations at home and abroad.

Macro expectations are the catalyst, and the decline in market liquidity is an important driving force behind the scenes.Since the spread of the epidemic in March 2022 and the closure of Shanghai, the volume of foreign exchange trading has declined significantly, which is likely to reflect the contraction of import and export trade. However, since Wednesday this week (April 20, 2022), the volume of spot foreign exchange trading has rebounded rapidly and basically returned to the level of the same period before the spread of the epidemic and in 2021.

However, no matter in terms of vehicle flow, freight flow, power generation in some areas or the throughput of the eight hub ports, the current economy and foreign trade are not optimistic.Behind the data is the decline in the depth of the market due to the contraction of foreign trade, the increase in the amount of foreign exchange purchased by banks, leading to sharp fluctuations in the market.

Panic buying foreign exchange? The impact on import enterprises is an even greater hidden danger.Judging from South Korea's export data in the first 20 days, China's imports are likely to continue to decline in April 2022, but foreign exchange purchases have increased significantly, indicating that foreign exchange purchases are not due to import trade. Judging from the data of Shanghai-Hong Kong Stock Connect, the performance of stock market funds is calm (figure 2). Then there are two possible reasons: a large outflow of funds from the bond market, or panic foreign exchange purchases by importers (of course, some enterprises do not rule out foreign exchange gambling).In the current context, the latter may be more worthy of attention than the former.

We need to guard against the positive feedback of import "deleveraging".Except for some speculative funds, foreign exchange purchases by enterprises (mainly importing enterprises) are mainly usedRepay trade credit or plan ahead for future imports.At a time when enterprises are facing the impact of epidemic situation and declining demand, the former should be the main weight. Import companies usually "leverage" when the RMB exchange rate is in the stage of appreciation.Enjoy the benefits of exchange rate appreciation through deferred payment through "trade credit + exposure unhedging"This is the story that has happened since the end of 2020, and the same version has happened before 2015 and 2017 (figure 12).

However, in the event of a significant exchange rate depreciation (or expected), due to a lack of protectionImporters will face huge exchange losses and panic foreign exchange purchases in order to avoid the expansion of losses, resulting in positive feedback of "devaluation-deleveraging-devaluation".This scene is likely to have taken place in the market this week.

The scale of trade credit for importers may not be smaller than that of bonds held by foreign investors.As of March 2020, foreign investors held 3.88 trillion yuan (US $610 billion) of bonds in the interbank market, according to safe.Trade-related credit balance in short-term foreign debt (within a year) at the end of 2021 is about $564 billion (this figure may be underestimatedAccording to the regulations of safe, some trade financing enterprises can choose whether to report it or not, such as Usance letters of credit within 90 days, overseas payment and so on, which is not uncommon.In terms of volume and payment rigidity, compared with foreign debt holdings, the exchange rate depreciation pressure caused by trade credit will be greater.

More noteworthy is that this positive feedback mechanism is likely to increase domestic inflationary pressures, resulting in an "impossible triangle" between exchange rate elasticity, inflation and asset prices.Exchange rate depreciation, rising commodity prices and a sharp contraction in trade credit may lead to a "fall in volume and price rise" in imports, while exchange rate depreciation will greatly reduce the role of exchange rate depreciation in promoting exports and production because of the containment of the epidemic, which will undoubtedly increase domestic inflationary pressure. President Yi Gang's emphasis on price stabilityInflation in 2022Is an important policy variable.In the second quarter of 2022, China may face a choice between exchange rate flexibility (non-intervention), inflation stability and asset price volatility:

Scenario 1: maintain exchange rate flexibility and control inflation = rising asset price fluctuations.Not to intervene in the exchange rate, while at the same time to control inflation, in addition to supporting the supply of the real economy, but also to prevent the import impact caused by the sharp depreciation of the exchange rate, the central bank may choose the policy combination of "tight money and broad credit"-- liquidity is prudent. Increase the use of structural policy tools for targeted broad credit, while credit transmission takes time and resumption of production, which is not good news for stocks and bonds in the short term.

Case 2: control inflation input, asset price stability = adjust exchange rate or use foreign reserves.To control inflation while keeping asset prices stable, the possible policy mix monetary policy remains loose, while regulating exchange rates and cross-border capital flows or using foreign reserves to stabilize exchange rates and imports, such as reintroducing counter-cyclical factors of exchange rates and reintroducing foreign exchange remote purchase risk reserves; adjusting macroprudential coefficients or implementing stricter regulation and window guidance on cross-border capital flows The central bank provides more dollar liquidity to the market. This is likely to lead to a continued appreciation of the real exchange rate, helping to curb imported inflation.

Scenario 3: maintain exchange rate flexibility, asset price stability = rising inflation.Similar to the operation of the Bank of Japan, in order to keep domestic asset prices (such as bond yields) stable and increase the release of water, this will lead to a sharp devaluation of the exchange rate without regulation, leading to a sharp rise in domestic inflationary pressures.

What we are experiencing may be similar to situation one, while the possibility of scenario two is on the rise.The central bank's recent monetary policy operation is obviously more cautious than before.In the context of previous globalization, scenario one may be the traditional mainstream means for us to deal with current economic contradictions.This is evidenced by the fact that double kill of stock and foreign exchange often occurs in several rounds of RMB depreciation cycle after 2015. ButAfter the epidemic, globalization has changed, and the escalation of the conflict between Russia and Ukraine has led to a qualitative change in the international situation. Taking the traditional road will only make the domestic economy and markets bear more costs of international turmoil, and the necessary intervention may be reasonable.For example, strengthen the regulation of exchange rate and cross-border capital flows.

Foreign reserves will be used to ensure exchange rate and import stability in the short term, and cross-border use of RMB settlement will continue to be promoted in the medium to long term.Credit Suisse star analyst Zoltan has advocated the "Bretton system III" in a series of recent reports, which is a long-term logic, but at least one point is very pertinent-the people's Bank of China, which has $3.2 trillion in reserves, is the breaker.

In the short term, the recent sharp fluctuations in the RMB exchange rate are due to the deep decline in the market.The people's Bank of China can use the US dollars in its hands to replenish liquidity for the market or for market makers, so as to prevent the exchange rate from opening and closing, so as to wait for the return of trade capital flows after the resumption of work and production.As the borrower of last resort, banks are encouraged to increase their support to foreign trade enterprises.Protect the smooth transition of the trade credit market and ensure orderly importsAt the same time, we will increase open market operations to reduce the base currency caused by the decline in foreign exchange share, so as to ensure reasonable and adequate liquidity.

And in the medium to long term,Expand the scope of RMB settlement, constantly improve the cross-border settlement system, and constantly improve the international status of RMBMaybe that's the answer to getting out of the impossible triangle, and it's also the answer to getting out of the dollar and Fed cycles.

Risk hint: the spread of the epidemic exceeded market expectations, and policy hedging against the economic downturn was less than market expectations.