The redback’s rising again

Six years ago usage of the yuan was growing quickly enough beyond China’s own borders that the currency merited mention in The Economist for its “remorseless and unstoppable” advance.

Yet its spread slowed markedly outside China after 2015, weakening claims that it would soon be challenging the US dollar as an international favourite.

So what to make of its rally against the dollar this year, when the yuan has made its biggest gains against the greenback since 2008 (up almost 5% this year)? Is it a signal that China’s currency is back in demand after a period of pause?

Much of the yuan’s ebullience is derived from growing confidence in the Chinese economy, which is showing signs of recovery from the Covid-19 crisis. On Monday China reported growth of 4.9% between July and September compared to the same period last year. That was a little below consensus forecasts but it was a much stronger performance than the world’s other large economies, some of which are likely to go back into recession as Covid-19 lockdowns are reintroduced.

The economic prospects in the United States are much more unclear, which has been weighing on the dollar. The situation in China looks more favourable, including an upgrade in its growth forecast by the IMF, a rally in the domestic stock markets and signals that domestic consumption rebounded strongly over the ‘Golden Week’ holiday at the start of October.

HSBC analysts note that “catering and food services sales returned to positive territory” last month, with consumer behaviour showing “signs of normalisation”. “The continuing recovery in income and jobs bodes well for future consumption, and we expect retail sales should continue to pick up in the coming months,” they add.

Investors are taking note, with foreign holdings of Chinese debt growing at the fastest rate on record over the summer, fuelled by substantial yield premiums on China’s sovereign notes compared to US government bonds of a similar tenor.

Such was the strengthening in the yuan that China’s central bank stepped in two weeks ago to slow some of the surge against the dollar by suspending rules that had made it more expensive for traders to bet on a depreciation in the domestic currency.

News of the changes saw the yuan suffer its biggest daily drop since March but it rallied strongly over the remainder of last week, forcing regulators to guide it lower again by setting the daily fix against the dollar towards the weaker end of the range (the fix restricts movement to 2% on either side).

Of course, yuan internationalisation is a longer-term story, dating back more than a decade. There’s a three-pronged plan to boost its standing outside its home market: first, increase its role as a means of payment in trade; next, promote it as an investment currency; and finally, spur its choice in the sovereign holdings of other nations.

Beijing’s hope is that the yuan will become an international reserve currency, posing a direct challenge to the dominance of the dollar.

How has the blueprint been working out? China’s central bank celebrated record levels of trade settlement in the yuan in its latest yearly review, with a new high of Rmb19.67 trillion ($2.83 trillion) last year, an increase of nearly a quarter over 2018. Yet the yuan is still punching well below its weight in trade terms. China took over as the world’s top exporter as far back as 2009 and became the biggest trading nation four years later. Against that backdrop the yuan’s share of trade settlement should be higher.

Currently it is used to settle about a fifth of China’s trade with other nations. But about half of the world’s trade is quoted in dollars, much more than the 12% of global trade generated by the US, according to a study by the IMF this year.

The disparity is greater if you look at the fuller picture of global payments, where the yuan was fifth-placed in August with a 1.91% share. It has been stuck in that position for about five years and is way back on the euro at 36.04%, with the dollar even further ahead.

The story is similar in international investment, where the yuan has made gains but still has a huge distance to travel. Critics of China’s currency plan say that global asset managers will be wary as long as the government maintains tight control of the exchange rate and imposes restrictions on how much capital can cross its borders.

The same sense of caution extends to sovereign reserves: admittedly the yuan’s share has doubled since 2016, but it accounts for just 2% of the worldwide total, compared to 62% held in dollar-denominated assets.

Disparities like these embolden the yuan’s detractors, although the currency’s supporters counter that the internationalisation process isn’t much more than 10 years old and that a lot more can be done to supercharge the yuan’s spread.

For a start there’s the rising contribution from Chinese consumer spending to global growth, which will trigger new pressures to transact more of the world’s trade in yuan. There could be more targeted ways of accelerating the process as well – one of the ideas circulating this autumn was that exports of Chinese-made vaccines for Covid-19 could be priced only in renminbi, for instance.

A move like that would probably be seen as too predatory by other governments, although the Chinese could still do more to set the terms of trade, such as stipulating that a greater share of their purchases of commodities like Saudi Arabian oil or Brazilian soybeans should be invoiced in yuan.

Another prospect is that more of China’s overseas loans are denominated in its own currency, especially for the funding of Chinese-backed projects along the Belt and Road Initiative. Beijing has done relatively little to exploit its geopolitical reach by lending in yuan: the massive majority of loans to developing markets – where China is now the world’s largest creditor – continue to be denominated in dollars.

Interest in the yuan from global investors will also deepen as the Chinese authorities open up more of the capital markets to outsiders. The inclusion of a wider range of Chinese assets in global bond and equity benchmarks is also going to be important: foreign investors will need to trade more in the yuan as these assets start to circulate overseas, which will fuel the internationalisation drive.

Another trend that could play a role in extending the yuan’s reach is the launch of a new digital currency under the direction of China’s central bank. Dubbed DCEP (or Digital Currency Electronic Payment: see WiC502), it has just gone through its biggest round of testing yet in Shenzhen, where 50,000 people have been using it via wallet apps linked to one of the Big Four state-owned banks.

The digital yuan has a domestic focus and there aren’t immediate ambitions to promote it outside China. But there will surely be chances to introduce it overseas, especially in countries more dependent on trade with China and in markets where Chinese-controlled digital payments brands are leaders.

What’s more, the People’s Bank of China has a clear vision for DCEP, describing virtual currencies as a “new battlefield” in China Finance, a magazine under the central bank’s auspices, last month.

China’s population is an increasingly cashless society, with more than 700 million users generating more than $49 trillion of non-cash mobile payments in 2019, up more than a quarter on the previous year. That is going to give the government an edge in rolling out the new currency format, which could eventually pave a way towards bypassing the Western banking system when doing transactions outside China.

“China has many advantages and opportunities in issuing fiat digital currencies, so it should accelerate the pace to seize the first track,” the piece in China Finance urged.

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