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Opinion: Why China’s Currency Is Becoming a Safe Haven

There are growing signs that foreign investors now treat the yuan as more of a safe-haven currency than as an emerging-market currency.

Not only has the Chinese currency appreciated around 6% against the U.S. dollar since mid-2017, the CFETS Renminbi (RMB) Index, which measures the yuan’s strength relative to a basket of currencies, has also risen by more than 4%, indicating that the yuan’s appreciation is not due to the weakening of the dollar.

Since mid-April, the U.S. dollar index has rebounded to January levels, but even though the yuan has recently fallen against the dollar, it remains well above its January level. The CFETS RMB Index has continued to appreciate, albeit slightly, in another sign of the yuan’s strength.

In addition, the several bouts of rapid yuan appreciation since mid-2017 were almost always accompanied by a rise in risk aversion and a spike in the CBOE Volatility Index (VIX), which measures expectations of market volatility. These spikes coincided with a spate of White House leaks in May 2017, growing tension between the U.S. and North Korea in August, and the global stock market downturn at the end of January. This suggests that the rise in risk aversion has often triggered yuan appreciation, which is not how the market usually treats emerging-market currencies. The South Korean won, for example, weakened against the U.S. dollar when the VIX surged. The market seems to no longer regard the yuan as an emerging-market currency, but more like the safe-haven currency of a mature economy.

The changing relationship between the yuan interest rate and exchange rate also seems to suggest a shift in global perceptions of the currency. Emerging-market economies usually maintain interest rates higher than U.S. Treasury bond yields to support their currencies. The relationship between yuan interest rates and the yuan exchange rate between 2014 and 2016 conformed to this general rule. But since the start of this year, yields on Chinese government bonds have fallen while those on 10-year U.S. Treasurys jumped to more than 3%, and the spread between Chinese and U.S. yields has narrowed to 60 basis points from 150 basis points. But this has not caused the yuan to weaken or capital outflows to increase. This shows that the yuan no longer shares the characteristics of other emerging-market currencies.

There has been speculation that the strengthening of the yuan is an attempt by the Chinese government to head off trade friction with the U.S., but this is unlikely. To begin with, the yuan started to appreciate in the second half of 2017, well before trade tensions between China and the U.S. escalated in March, when the yuan basically stopped rising.

In addition, China’s bargaining power in any trade war is significantly stronger than Japan’s was against the U.S. in the 1980s. China has learned lessons from Japan’s experience, and it is extremely unlikely that the Chinese government will actively encourage the yuan to appreciate significantly. Since the beginning of the year, the yuan’s daily closing price has been significantly higher than the midpoint set by the central bank, indicating that the yuan’s appreciation is increasingly market-driven. This is a marked change from the situation at the beginning of 2017, when the yuan’s value rose significantly on a few occasions, but only because of action taken by the central bank.

The yuan has held onto its gains because of increasing global demand for yuan assets. While the continuous appreciation of the yuan from 2005 to 2013 reflected net capital inflows on the current account, the current bout of yuan strength reflects net inflows of direct investment.

The domestic bond market has clearly been affected by the growing enthusiasm of foreign investors for government bonds. Yields on three- and five-year Chinese government bonds have been pushed down by foreign-investor buying. The total value of domestic bonds held by overseas institutions has increased by more than 500 billion yuan ($78.5 billion) in the past year, a 67.8% surge, according to figures from the China Central Depository & Clearing Co. Ltd. and Shanghai Clearing House. In the first quarter of 2018, overseas institutions’ holdings of domestic bonds have already risen by almost half of the increase seen in the whole of 2017. Nearly 6% of Chinese government bonds were held by foreign institutions in the first quarter — a record high.

There are three main reasons why foreign capital now favors yuan assets.

The first is enhanced confidence in China’s ability to withstand external risks over the medium and long term, and its ability to avoid a “hard landing” for its economy because of supply-side reforms and the deleveraging campaign, which have lowered the risks posed by overcapacity and high real estate inventory levels. If the trade conflict with the U.S. escalates, negatively affecting the global economy, China’s economy will remain more stable than other emerging markets and even some smaller developed economies. This is one of the main reasons why the yuan is becoming a safe-haven currency.

The second reason is the “rigid demand” for yuan assets stemming from the internationalization of the currency and the opening-up of the Chinese market. The euro was added to the International Monetary Fund’s Special Drawing Right (SDR) basket of currencies in 2001, and its weighting was increased from 29% to 34% in 2006. As a result of these changes, the euro’s share of global foreign reserves rose from 17% to 25% between 2001 and 2003, and to 27% by 2009. The yuan, which was added to the SDR basket in 2016, will likely undergo a similar process.

The third reason is that the correlation between yuan assets and foreign assets is relatively low, so investing in yuan assets can effectively improve a portfolio’s risk-return ratio, and increase diversification. The correlation between China’s CSI 300 Index and the S&P 500 Index has been only 0.25 since 2009, far lower than similar figures for Germany’s DAX Index and South Korea’s KOSPI index, which are around 0.8 and 0.6 respectively. The trend of Chinese government bond yields has also in recent months been out of sync with the trend of bond yields in developed economies.

Xu Xiaoqing is the chief macroeconomist of DH Fund Management Co. Ltd.

Translated by Teng Jing Xuan (jingxuanteng@caixin.com)

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