Strong and stable?

“Our currency, but your problem” was the unsympathetic verdict from Richard Nixon’s Treasury Secretary John Connally (or ‘Typhoon’ Connally as he was known by his Japanese contemporaries) in late 1971 at a meeting of finance ministers in Rome.

The comments were said to have astonished his counterparts and the brash remark is still seized upon today by those who warn against the dollar’s dominance as a reserve currency.

Back then the greenback was collapsing as a consequence of Washington’s decision to end its commitment that foreign governments could exchange their dollars for gold. But more than 50 years later the dollar is moving in the opposite direction against other currencies, hitting its highest levels since 1985 in trade-weighted terms, according to the Bank for International Settlements.

Currencies including the yen, the euro and the pound have all trembled in its wake, while the Chinese yuan has also fallen steeply this year, with no sign over the last few weeks that its slump is set to slow.

China’s currency bosses are clearly concerned by the yuan’s descent, with speculation that more action may be imminent as Beijing bids to bolster its currency against the domineering dollar.

But there are also limits to what policymakers can achieve in defending the redback, analysts say, and yuan weakness may persist in the shorter term.

What’s happened to the yuan-dollar exchange rate this year?

The yuan has fallen about 11% against the dollar and it is expected to finish the year with its biggest decline against the greenback since 1994.

In September alone it weakened 3.3% in onshore trading, with the USD-CNY breaching the psychological level of 7.00 before closing the month at 7.116.

The situation has been similar in trading of the currency outside China.

Declines like these are a concern for Chinese policymakers, who worry about an acceleration in capital flight as investors try to get their currency holdings out of the country and convert them into alternative choices. Beijing seems to have plugged many of the channels that triggered the most destabilising outflows in previous periods of yuan depreciation, however, allowing the People’s Bank of China (PBoC) more flexibility in setting its monetary policy goals.

Another concern about a dramatic decline in the value of the yuan is imported inflation, with higher priced goods from overseas starting to weigh on the cost of living for Chinese consumers. There’s already evidence that imports are slowing, says Caixin magazine, with goods imports rising 4.6% year-on-year in dollar terms in the first eight months of the year, much slower than the 35% growth for the same period in 2021.

Of course, a weaker yuan should be better news for exporters by making it cheaper for foreign companies to buy Chinese goods. But some of the benefits here have been offset by weakening demand in overseas markets because of inflation and the monetary tightening pursued by other central banks. Growth in China’s goods exports actually slowed to 7.1% year-on-year in August from 18% in July, Caixin adds. The latest purchasing manager indices from the manufacturing sector signal that overseas demand was contracting in September at an even sharper rate than in August too.

Why is the yuan weakening against the dollar?

Much of the reason is related to differences in monetary policy between Beijing and Washington, a situation that WiC has been tracking since earlier this year.

While the Federal Reserve continues to push up US interest rates as part of its battle against inflation, China has been keeping its rates low in a bid to boost its economy, which has been battered by Covid lockdowns and a distressed property market.

While the Fed ratchets rates higher, with another hike expected in November, the PBoC has headed in the opposite direction, cutting the key one-year medium-term lending facility rate in August, allowing commercial banks to reduce their deposit rates in mid-September, and loosening the lower limit on mortgage rates for first-time homebuyers at the end of the month as well.

The yuan’s slide is also sending a message on China’s sputtering economy, however, which barely grew in the second quarter. Covid controls have dampened consumer sentiment and the property market is stuck in crisis mode as developers struggle to complete construction of new projects, while potential homeowners hold back on new purchases.

These realities mean that policymakers need to concentrate more on getting the economy firing again than intervening in the foreign exchange markets, says former central bank adviser Yu Yongding.

“US Fed rate hikes have put some pressure on China’s macro-economic policies. But fundamentally the challenges are internal,” Yu told ThePaper.cn, turning the focus back to the Chinese economy and the need to “resolve problems that affect growth”.

“The long-term rate of the yuan depends on people’s perspectives towards China’s economic system and their confidence about the prospects for growth,” he emphasised, acknowledging that the government is trying to boost the economy with expansionary policies, but warning that Covid-19 controls could limit the potential gains.

How else has Beijing been trying to halt the yuan’s decline?

Currency regulators have been restrained in reacting to the yuan’s drop against the dollar, sticking to expressions of verbal support for the currency and making technical tweaks around the exchange rate intended to stabilise its value against the greenback.

Last Wednesday there were stern warnings from the central bank against speculators on the exchange rate, for instance. “Do not bet on one-way appreciation or depreciation of the yuan, as losses will definitely be incurred in the long term,” the PBoC said in a statement. “The foreign exchange market is a big deal. Maintaining stability is the first priority,” it added, highlighting how the central bank “has accumulated rich experience in coping with external shocks and can effectively manage market expectations.”

Most of the interventions from the PBoC have been minor, or more technical, so far. It deploys a managed float system in which it sets a daily fixed rate for the yuan against the dollar based on quotes received from 14 major banks every morning. Onshore trading in the yuan can then only move within a range of 2% of that point. This morning call is an important reference point for traders, who watch it for guidance on how the PBoC might be trying to set a fix that is stronger or weaker than their own estimates.

What’s been happening for much of the last month is that the central bank has been setting the fix for the yuan at a stronger level than the average estimates from traders in the market. Bloomberg was reporting at the end of last week that the PBoC had set stronger-than-expected fixings for 26 straight sessions, for example, the longest run since the news agency first started to survey market participants on where they thought the fixing would be set in 2018.

In other tweaks, the PBoC is said to be guiding the banks to add a “countercyclical adjustment factor” to the existing mechanism, a technique implemented during previous periods of yuan weakness to iron out depreciation pressures without necessarily drawing a firm line in the exchange rate, Reuters says.

In another bid to make it more expensive to bet against the yuan in derivative markets, the central bank has added requirements for banks to deposit reserves when buying foreign currency through forward contracts.

As yet, there hasn’t been a fuller or more dramatic intervention in the currency markets. Rumours that something was afoot did have a momentary impact last week, when the yuan strengthened against the dollar on reports that the PBoC had instructed state-owned banks to get ready to sell dollars and buy yuan in offshore markets. But nothing major has materialised since then to substantiate the reports. Commentators say that Beijing is cautious about a fuller intervention because of its experience seven years ago when an effort to devalue the yuan triggered a flood of capital outflows (as much as $2 trillion left the country by some estimates), unleashing a further round of unwanted downward pressure on the yuan.

Is the yuan doing better against other currencies?

One reason why the Chinese haven’t intervened to bolster the yuan more is that it has held up against the dollar better than many of its peers. Other currencies like the pound, the yen and the euro have fallen further and faster against the greenback.

China’s central bank also talks increasingly about managing the yuan against the currencies of a wider group of trading partners, and not solely against the dollar, and Chinese officials have been quick to point out that the yuan has held up well against a trade-weighted basket of currencies, sitting at levels similar to the start of the year.

That was the reference point in another meeting of the PBoC last week, which ended with a statement that the yuan’s exchange rate had maintained “basic stability” and that, although it had depreciated against the dollar, it had appreciated markedly against the euro, the yen and other currencies.

In fact, the yuan stands out as one of the few strong currencies in the world so far this year, the Global Times believes, playing a role as an anchor of stability in the region.

Some of that view is accurate: if the yuan were to fall heavily against neighbouring currencies, it might create even bigger problems by triggering a fresh wave of competitive devaluations as other nations look for ways to bolster their own exporters against China’s.

However, it also leaves analysts wondering whether this could make it harder to boost the yuan to the upside, reducing Beijing’s room for maneouvre against the dollar.

What does it say about the yuan’s prospects over the longer term?

At least the comparisons to the Japanese yen and the Korean won allow Chinese policymakers to get back to the narrative of a strong and stable yuan, reflecting a strong and stable country.

It’s harder to make quite the same claims about the yuan’s current standing against the greenback, of course, which is also the currency pairing that tends to get more of the media attention.

The yuan’s weakening against the dollar will also be an irritant to China’s political leaders in a context in which a stronger currency is typically trumpeted as a signal of the nation’s economic achievements. There’s also the immediate backdrop of the 20th National Party Congress, which will gather later this month to confirm Xi Jinping’s third term as Chinese president. This should be an occasion to celebrate the achievements of China’s leaders, portraying them as all-powerful in policymaking terms, or at least as more impactful than their peers from other countries. But in the case of the declining yuan, it is clearly the market setting the mood, not the Politburo elite.

­­For years there has also been hope of the yuan becoming a significant currency outside China, with talk of a political mission for the redback in challenging the dollar’s grip on global finance (for more on the background, see ‘Ready for the RMB?’, one of our Focus editions).

Yet while it’s true that usage of the yuan outside China has been increasing, the currency’s advance has been slower than many people anticipated.

The latest data from the RMB Tracker, a survey authored by financial messaging service SWIFT, shows it in fifth place in global payments by value, with a share of 2.31% in August. That was well below the euro at 34.49% share and even further back on the dollar at 42.63%.

The yuan came in higher – in third – as a trade finance currency, with a slightly larger share of 3.67% in the same month. But that was a huge distance behind the dollar’s share of just over 85% and an even starker underrepresentation of the contribution of Chinese firms to global trade, where China is the world’s largest exporter.

Statistics like these highlight how the dollar is still in the driving seat as a trade and investment currency, while the events of the last few weeks are a reminder of how investors gravitate back to the greenback during times of market turmoil and financial stress.

And yet the story of the yuan’s international journey is still much discussed in China, where signs of progress are lauded as signals of the country’s expanding reach.

Hence the reports in the media this week that the yuan had become the most traded foreign currency on the Moscow Exchange on Monday, with trading turnover in the yuan-rouble pair surpassing dollar-rouble business for the first time.

For China’s newspapers this was an achievement of some significance, although they avoided much mention of the set of circumstances that have allowed the yuan’s rise to top spot in Russia this month.

Instead the Global Times kept up the focus on the inevitability of the greenback’s demise, with predictions that the current bout of dollar strength will only accelerate its eventual decline as a dominant force.

“As the credibility and reputation of the US dollar system is at a higher risk of collapsing due to Washington’s irresponsible monetary policy, de-dollarisation is viewed as a forthcoming trend, with more markets likely to recognise the yuan’s internationalisation over the long run,” Chen Jia, a research fellow with the International Monetary Institute of the Renmin University of China, added approvingly to the piece.

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