China walks a tightrope with rapidly rising yuan

Yi Gang isn’t known for his acrobatic skills. Yet these days, the People’s Bank of China (PBOC) governor could be excused for feeling like he’s trying out for Cirque du Soleil.

The balancing act in question concerns a Chinese currency rapidly decoupling from the US dollar – with the yuan rising, rather than doing its usual weakening act.

The tightrope Yi’s team is walking is clear enough. His team must serve both growth demands and the de-risking process he’s pursued since taking the PBOC helm in 2018.

The yuan’s strength can seem paradoxical given the default risks highlighted by China Evergrande Group, the property developer that missed a bond payment last week. Also, the PBOC is loosening monetary policy, albeit slightly, as the Federal Reserve tapers.

Looked at another way, the combination of capital inflows and surging mainland exports has meant increased, and largely organic, demand for the yuan since September. The PBOC could use these dynamics as ammunition should President Xi Jinping’s men complain.

A strong yuan, in other words, makes sense. Yet this currency decoupling is an uneasy one. And it greatly adds to intrigue about where exchange rates are headed in 2022.

Between 2015 and mid-2021, the dollar-yuan relationship had been remarkably consistent and predictable. Since September, that dynamic has broken down.

This gets us back to the PBOC’s balancing act. Yi’s team is taking a more hands-on approach to the yuan’s 3% gain this year. Even so, there are at least three reasons to favor a stronger yuan exchange rate in the months ahead.

Cause for a strong yuan

One is global inflation. At the moment, this is more of a dilemma for the US, where consumer prices are rising at their fastest clip in 40 years. Though China’s factory gate prices recently jumped to 26-year highs, these pressures have yet to filter through to households.

A stronger yuan reduces the risks of importing inflation – and limits the chances of economic overheating.

Two: There are many overseas bond payment dates on the horizon. Though China bears little in common with the economies embroiled in the 1997-98 Asian financial crisis, officials in Beijing understand well the risk of having to make big dollar payments with a weak currency.

A firmer yuan will, at the margins, help Evergrande, Fantasia Holdings, Kaisa Group and other beleaguered property companies meet their debt obligations. It also might encourage international credit rating companies to go a bit slower in downgrading mainland developers in the months ahead.

Three: a stronger yuan is a necessary part of China building a vibrant domestic demand-led growth model. Part of what Xi meant back in 2012 when he pledged to let markets play a more “decisive” role in Beijing’s decision-making was the need to shift to a more services-based growth model.

The more China pivots away from smokestack industries, the less short-term growth depends on exchange rates. The more purchasing power mainland households have, the greater China’s role in global decision-making will become. For years, the G-7 nations urged Beijing to become a global stakeholder, not just a shareholder. A strong yuan could finally answer that call.

And yet, what a difference a year makes. Twelve months ago, outgoing US president Donald Trump couldn’t seem to complain enough about a yuan exchange rate he believed was “killing” American living standards. As December 2021 began, strategist Marc Chandler at Bannockburn Global Forex was calling the yuan’s performance the “best in the world.”

Steady as she goes

This, not surprisingly, has the PBOC taking actions to steady the yuan, says economist Khoon Goh at Australia & New Zealand Banking Group. One risk, notes strategist Hao Hong at Bocom International Holdings, is that “some of the flows” into Xi’s economy right now “will be hot money.” That, after all, is what got developing Asia in trouble back in 1997.

Analyst Wei He at Gavekal Research says that the December 6 cut in reserve requirement ratios for banks “is a clear signal to markets that the PBOC wants to cool down currency appreciation.”

In recent months, He adds, “the PBOC has had a largely hands-off currency policy, doing little to push back against the gains in the renminbi. The main driver of currency strength is China’s exports, which have continued to defy expectations of a slowdown and thus kept the current-account surplus high.”

He noted that “the main exception to that hands-off policy – the PBOC’s previous moves in May to restrain currency appreciation – was driven by its longstanding practice of intervening to break up ‘herd behavior’ in currency markets that it felt had become too one-sided.”

Officials in Tokyo have long perfected the exchange-rate science of guiding the yen where they desire in an orderly fashion. That way, markets don’t panic and trading partners don’t retaliate. The PBOC seems to have taken a page from the Bank of Japan and Tokyo’s Ministry of Finance.

Yet managing flows may become more complicated in 2022. Analyst Flora Zhu at Fitch Ratings says “we expect total FDI in China to see more inflow from the 14 member countries of the Regional Comprehensive Economic Partnership, which will take effect in 2022.”

Member countries, which include Singapore, South Korea and Japan, together accounted for 42% of China’s total FDI in 2020, excluding Hong Kong and Macau.

In general, she notes, “China’s strong foreign direct investment growth, which reached a record high” in the first 10 months of this year will likely “continue rising, underpinned by a robust mergers-and-acquisitions deal pipeline and increasing intra-regional cooperation.”

Analyst Kelvin Wong at CMC Markets Singapore adds that the “strong” yuan has been a “magnet” to attract inflows. Generally speaking, such capital is a boon for mainland equities and a government bond market that Xi is keen to continue growing and internationalizing.

Here comes the Fed

Yet an equally strong case could be made that US Federal Reserve rate hikes could stall, or reverse, yuan strength. Steven Blitz, an economist at TS Lombard, speaks for many when he says the Fed could tighten by March 2022.

“The timing is being pulled forward because the circumstances for starting a rate hike cycle that were anticipated a year ago are onrushing with unanticipated speed,” Blitz says. “To be clear, our call is not about the current shortage-related price spikes. It is about an inflationary process – wages and, soon enough, borrowing – taking hold and the Fed belatedly recognizing they need to catch up.”

That could make for quite a tug of war between the US and Asia. But China could be an outlier if the PBOC goes all out to put a floor under the exchange rate, accelerating decoupling between the two biggest economies.

One wild card is how Xi’s inner circle responds to the PBOC not acting more assertively to cap the yuan. Beijing regulators are dropping hints that Yi’s team should not take their quest for decision-making independence too far. This balancing act could become more precarious as 2022 unfolds.

Another is how exchange rates factor into Xi’s relationship with US President Joe Biden. The wise move would be for Xi and Biden to cooperate on exchange rates.

As US National Security Advisor Jake Sullivan suggested in January, sitting down and hammering out a currency pact, 1985-style, may be mutually beneficial to the Group of Two. That earlier deal, agreed to at New York’s Plaza Hotel, had the dollar weaken versus the yen.

Economist Zack Cooper at the American Enterprise Institute notes that “leaders in both countries remain concerned about the potential for that interdependence to be weaponized. The Biden administration has therefore stressed the need to secure supply chains, while Beijing has talked about ‘dual circulation,’ which would reduce its own dependence on foreign markets.”

Exchange rates, though, are a place where Xi and Biden could find face-saving ways to balance the needs of the globe’s economic superpowers. It sure would make Yi’s highwire act a whole lot less precarious. And calm nerves in markets everywhere.