In Depth: What’s Next for the Yuan After Crushing the Dollar for Six Months
Notwithstanding growing tensions between Washington and Beijing and the Covid-19 pandemic, now is a good time for Chinese mainland tourists to hop on a plane to the U.S. –– the appreciation of the yuan over the past six months means they are getting far more bang for their buck.
At the end of May, they needed to exchange 7,146 yuan to get $1,000, but on Monday they would only have had to part with 6,537 yuan, a saving of 609 yuan, or 8.5%, according to the central bank’s official closing price. The yuan has been the second-best performer against the U.S. dollar among Asian currencies since it hit a closing low of 7.16 yuan on May 28, beaten only by the South Korean won.
The Chinese currency’s rapid appreciation over the past six months to its strongest level against the dollar in nearly two and a half years has raised concerns among some analysts that it has strengthened too quickly and could have an adverse impact on exports — in an analysis of November’s official manufacturing Purchasing Managers Index, the National Bureau of Statistics noted (link in Chinese) that 18.8% of export companies said they were affected by fluctuations in the exchange rate, up from 17.1% in October, and some survey respondents said appreciation had put corporate profits under pressure and led to a decline in export orders.
Even so, some analysts say Chinese policymakers’ tolerance for appreciation is set to continue.
“Comments from senior officials … suggest that appreciation is currently looked at favorably in Beijing, since it makes yuan-denominated assets look ‘competitive’ internationally,” Louis Kuijs, Hong Kong-based head of Asia economics at research firm Oxford Economics Ltd., told Caixin on Wednesday. “Barring drastic FX (foreign-exchange) pressure, I expect the authorities to maintain this stance in 2021.”
Kuijs said he expects the yuan to be trading at 6.6 per dollar at the end of 2020 and sees further appreciation to 6.5 by the end of 2021, although he expects to see “significant exchange-rate fluctuations over and above the underlying trend, consistent with the direction of reform.”
London-based research firm Capital Economics Ltd. sees even stronger gains, estimating the yuan will appreciate to 6.2 per dollar by the end of 2021, partly because of a persistently large gap between yields on Chinese government bonds (CGBs) and U.S. government bonds, which will attract overseas demand. CGBs offer a much higher return than U.S. Treasuries — the 10-year yield differential has risen by over 200 basis points since the end of 2019, the firm noted in a Dec. 8 research note.
Analysts and participants in the foreign-exchange markets interviewed by Caixin say now is not the time for regulators to step in and halt the appreciation because it is not being driven by speculation but by fundamental factors such as a strong economy, booming exports, and inflows of overseas money investing in China’s capital markets. Instead, policymakers should take advantage of the yuan’s strength to introduce more flexibility into the current exchange-rate formation mechanism and give the markets a bigger role in deciding the yuan’s value, as they have been promising for several years.
The People’s Bank of China (PBOC), the central bank, has gradually been introducing more flexibility into the yuan exchange-rate mechanism since the last major round of reform in August 2015, when it shocked global markets by changing the way it calculated the daily reference rate, also known as the fixing, for the currency’s value against the dollar.
The yuan is still only allowed to move by a maximum of 2% either side of the reference rate which is published each trading day at 9:15 a.m. local time, but the fixing is now more volatile and the PBOC allows it to be more market-driven. In October, the central bank scrapped the counter-cyclical factor, a key element of the way it sets the daily reference rate originally introduced in 2017 to stem the yuan’s depreciation. That has given traders more of a say in determining the yuan’s value.
China’s foreign-exchange market has matured since the 2015 reform and the public has increasingly adapted to the more flexible yuan, said Li Liuyang, a forex analyst at China Merchants Bank Co. Ltd. Increased exchange-rate flexibility means that investors and traders can respond more quickly and efficiently to new market information and take new long or short positions based on their changed expectations, Li said.
Financial regulators need to have more tolerance for fluctuations in the exchange rate, said Guan Tao, chief global economist at BOC International (China) Co. Ltd. “We have to believe that in the context of the marketization of exchange rates, the exchange rate will rise and fall –– it can’t only rise or only fall. If we never trust the market, we can never go down this road” toward a market-based exchange-rate mechanism, Guan said.
In the past, some spurts of yuan appreciation against the dollar were driven by speculation which the central bank worked hard to stamp out, mostly through starving the offshore yuan market in Hong Kong of liquidity and ordering financial institutions to sell the Chinese currency to satisfy demand.
But the current stretch of gains is being fuelled by fundamental factors, analysts say. One driver is the rebound in exports since the depths of the Covid-19 pandemic in the first quarter, a financial regulatory source told Caixin. Appreciation driven by fundamentals is reasonable and if regulators take measures to block it, pressure will only continue to build, the source said.
Although in the past yuan appreciation had a negative impact on overseas sales, the historic correlation between the exchange rate and exports has been disrupted by factors including the Covid-19 pandemic and the U.S.-China trade war, said Zhong Zhengsheng, chief economist at Ping An Securities Co. Ltd. That suggests the yuan’s recent rally will not have a substantial impact on exports until the pandemic fades, he said.
Another driver is the recovery in economic growth since the historic slump in the first quarter. GDP expansion has picked up speed and was 4.9% year-on-year in the third quarter, boosting the confidence of investors, companies and consumers in the world’s second-biggest economy. The International Monetary Fund is now projecting 1.9% GDP growth for the full year, compared with a forecast contraction of 4.4% for the world as a whole. In 2021, the IMF estimates China’s economy will expand 8.2%, way faster than its projection of 5.2% growth for the global economy.
China has steered clear of the massive fiscal stimulus rolled out by most major economies hit by the coronavirus, and avoided implementing an excessively loose monetary policy and slashing interest rates. That’s meant returns on assets in China are higher than those in many other countries which has lured global investors and pushed up demand for the yuan. Global investors are also less keen to hold U.S. dollar assets owing to the economic chaos in the U.S. caused by the spread of the coronavirus and by the lack of a strategy by President Donald Trump’s administration to bring it under control. As of Monday, the U.S. dollar index, which measures the value of the dollar against a basket of currencies of the U.S.’s most significant trading partners, had dropped more than 7.7% since the end of May.
In China, foreign exchange trading is tightly controlled to prevent currency speculation and stabilize the exchange rate. In order to increase the yuan’s flexibility further and give the market more of a say in determining its value, some analysts and market participants say regulators need to ease up on some controls. Currently, when importers or exporters exchange foreign currency through a bank, bank officials have to check documents such as contracts and customs declarations that prove the trading is for real business.
But these controls deny businesses the freedom to buy and sell foreign exchange at will to hedge against currency fluctuations. If traders think the yuan is cheap and want to buy more because they think it’s going to appreciate, they can only buy based on their business’ trading volume and are not allowed to buy more, a source in the foreign exchange market explained to Caixin. Regulators should relax checks on documentation when there is a large fluctuation in the exchange rate so that exporters and importers can buy or sell currency more freely in order to hedge their foreign exchange risks, the source said.
Cross-border capital flows are another key factor affecting the exchange rate and as a result are also subject to strict controls. When capital was pouring into China in the decade through 2014 and the yuan was appreciating, the PBOC was more concerned about controlling inflows, but since 2016, the focus has been on preventing outflows to rein in depreciation pressure on the currency and preserve the country’s foreign exchange reserves.
However, as confidence in China’s economy has improved and the government has further opened up the capital markets to overseas money, inflows have returned and forex regulators have signaled an easing of restrictions on money leaving China to take some of the heat out of the yuan’s appreciation pressure.
In September, for example, the State Administration of Foreign Exchange (SAFE) issued $3.4 billion of new quotas for the Qualified Domestic Institutional Investor (QDII) program that allows domestic investment in overseas securities markets. It was the first addition in 22 months and took the total quota (link in Chinese) issued since the program started in 2006 to $117 billion.
The SAFE is considering further increases in QDII quotas to send a message of openness to the market, sources familiar with the issue have previously told Caixin.
Some analysts argue that investment quotas should not be used to try to influence the exchange rate. If regulators open up immature capital outflow channels as a way of easing yuan appreciation pressure, then once the situation reverses, investors could then use this same channel to take capital out of the country, Guan said. If policies are then changed back, it damages the image of openness the government wants to portray, he said.
The million-dollar question now is: for how much longer can the yuan keep appreciating. Part of the answer lies with the U.S. dollar, the world’s dominant currency and that, in turn, will depend to a great extent on the economic policies of U.S. President-elect Joe Biden, whose inauguration will take place on Jan. 20. So far, his policy agenda suggests he will implement an expansionary fiscal policy to support the economy through the Covid-19 pandemic and that will keep the dollar weak, many analysts say.
Biden is also widely expected to start repairing relations with its trading partners which would also benefit other currencies, said Li from China Merchants Bank. That could see the dollar index fall by 4% to 5% from its current level. Under that scenario, the yuan could appreciate by another 2% to 2.5%, Li said.
A broad-based global economic recovery and mass coronavirus vaccination program could also increase international investors’ appetite for more risky assets, which would favor China and other emerging markets. However, other factors could make markets more risk averse, according to Ping An Securities’ Zhong, who pointed to uncertainty over, or disruption to, the handover of power from the Trump administration to the new president, a resurgence of Covid-19, and a higher global debt burden resulting from the pandemic. That would increase demand for dollar-denominated assets, which are seen as a safe haven in times of trouble, and could spell the end of the yuan’s spectacular run.
Contact reporter Guo Yingzhe (firstname.lastname@example.org) and editor Nerys Avery (email@example.com)
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