China, the dollar dictates the law on the yuan: possible devaluation of the currency?

Dollar strength renews downward pressure on yuan

The People’s Bank of China (PBoC) has effectively fixed the exchange rate between the yuan and the U.S. dollar (USDCNY) for the past 12 months. With the US dollar continuing to hold strength, most currencies have weakened against the dollar much more than the limited movement seen by the CNY.. As a result, the CNY strengthened against the trade-weighted basket of currencies (the so-called CFETS basket).

While some market participants may use this as a reason for an impending one-off devaluation of the yuan (similar to that of 2015), it is important to note that China’s trade competitiveness is currently at its highest level in 10 years. Thanks to much lower inflation than its trading partners, China’s real effective exchange rate (REER) is currently at its lowest level in 10 years. Using the producer price index to deflate nominal exchange rates, China’s REER is the weakest since the global financial crisis. Export volumes have grown robustly, implying that the nominal strength of the CNY against trading partner currencies should not be a concern.

It is true that widening yield differentials with the United States have put pressure on the USDCNY. While China’s trade and current account surpluses remain large, exporters have not necessarily brought dollars back into the country.. Net foreign exchange settlement data clearly shows that demand for foreign exchange has increased, although it has not reached a level comparable to that of 2015. During the first half of 2023, the PBoC let the renminbi depreciate against the US dollar, but began to limit the currency’s movement to a very narrow range in the second half of 2023. Without the authorities’ currency management, the renminbi’s weakness would likely be comparable to that of other Asian currencies.

Why have Chinese authorities resisted the depreciation? One hypothesis is that the PBoC does not want the renminbi to weaken beyond a certain psychological level against the US dollar. A breach of that level could quickly erode the confidence of Chinese residents and lead to new capital outflows as in 2015. The recent strong demand for gold by retail investors is a manifestation of the desire to diversify from CNY-based investments. Low interest rates and a weak real estate market have long limited Chinese investors’ domestic financial investment choices, increasing capital outflow pressures.

Another reason not to let the renminbi become too weak against the US dollar is the risk that trading partners will implement trade restrictions.. The last time China was labeled a currency manipulator was in 2019, during the Trump presidency, after the renminbi weakened in response to US tariffs. With the US election looming, China cannot afford to take this risk, especially as it is trying to use exports to drive economic growth this year. Of course, the risk of depreciation remains if Trump is elected and imposes large tariffs as per his campaign slogan. Proponents of an imminent CNY devaluation argue that China needs to further loosen its monetary policy to support domestic demand and escape the deflation trap. A reduction in interest rates in China would mean an even wider differential with the US.

However, we do not expect any significant rate cuts from the PBoC, as it takes the difficult external financial conditions as a given.. The PBoC is not keen on its actions increasing pressure on the currency. However, it may start to loosen its grip when the Fed starts cutting rates. In our view, fiscal and housing policy are more important to support domestic demand and sentiment. The latest Politburo statement suggests that the authorities would like to step up fiscal pressure by bringing forward bond issuance. The language on monetary policy “flexibility” has remained largely unchanged from the past. One piece of good news is that the Chinese authorities have finally set a date for the Third Plenum, a time for a national congress focused on structural policy. This could be an opportunity to introduce structural measures that would help fix local government finances and boost consumption.

*Emerging Markets Economist by J. Safra Sarasin