RMB's solid performance got the market transfixed

And there’s no slowing down for now.

The RMB’s strong performance has caught the market's attention, as since early June, the RMB has been a top performer, not only against major currencies struggling with low inflation and low yields, but also against most EM currencies.

According to a research report from HSBC Global Research, in its view, the following key factors have led to this reversal in the RMB’s fortunes: FX policy turning more tolerant of RMB appreciation; a shift in the flow structure away from ‘hot money’ inflows; prudent monetary policy; a strong reform agenda.

These factors are expected to remain in place in the coming months, which suggests that the RMB should remain broadly strong into the end of the year.

Here's more from HSBC Global Research:

While official intervention is on the sidelines for now and RMB strength could overshoot, we cannot lose sight of China's FX policy having a goal of inducing greater two-way flexibility for the RMB. We still expect this to emerge, which could also coincide with greater fixing volatility ahead.

One of the key drivers of the RMB rally has been the flattening out in the trend of the PBoC’s daily USD-CNY fixing.

This onshore USD-CNY fix has been in a range of 0.50% (between 6.1425 and 6.1710), since the beginning of June, after having risen by 1.2% in the five months before that.

This relative stability has been in contrast to the rally in the broader USD of nearly 5% (as measured by the DXY index).

If the PBoC had been tracking EUR-USD movements via its daily USD-CNY fix (EUR-USD makes up 57.6% of the DXY index), it should have then risen by 500 pips by our estimation since the beginning of June (i.e. the CNY would have been weaker).

Instead, the USD-CNY fix has dropped by 240 pips over this period – unexpectedly tolerant of RMB strength. This is a complete reversal of the fixing pattern implied by EUR-USD’s movements earlier in the year.

This highlights how the USD-CNY fix has become less predictable this year, or at least for those that have been trying to predict the fix via a DXY model-based method.

This is similar to 2012 when the USD-CNY fix showed more flexibility and China's policymakers frequently mentioned that the RMB was approaching an equilibrium level.

This implies that the USD-CNY fix may soon become more volatile and track the spot rate better, which will in turn let the RMB appreciate when growth data, together with the trade balance, comes within or above policymakers' targeted range, and vice versa.

If this is indeed the case, then the elasticity of the currency would increase over time and its importance as a counter-cyclical policy tool would rise.

Such a fixing mechanism would also facilitate monetary policy reforms by reducing FX reserve accumulation to achieve greater independence between FX and interest rates policies.