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Market pressure on the People’s Bank of China to allow the renminbi to weaken is mounting as traders bet the yawning gap with U.S. borrowing costs will lead more investors to sell the Chinese currency.
China’s central bank has maintained a strong yuan policy so far this year, keeping its daily fixed (the reference rate around which the currency is allowed to trade) within an unusually narrow range of 7.09 to 7.11 against the US dollar has kept.
But the currency recently traded as much as 2 percent below its fixing rate — the maximum variation the central bank says it will allow — for the first time in eight years, indicating increasing selling pressure.
Markets are pushing for a weaker yuan to reflect the difference in bond yields with the US: 10-year government bond yields are at 4.57 percent, while Chinese 10-year government bonds offer just 2.3 percent. Capital typically flows to markets where interest rates are higher.
“A large number of traders expect a one-off depreciation of the yuan, similar to what occurred in 2015, due to the massive downward pressure that has built up in recent months,” said a Shanghai-based currency trader.
In 2015, China suddenly devalued the renminbi, which it considered overvalued. That caused turmoil in financial markets, including sharp selling of the yuan by global managers, severe capital outflows and a 1 trillion yuan drop in foreign reserves, as regulators intervened to calm markets.
The central bank is currently reluctant to allow a rapid change in the exchange rate, instead promoting stability. President Xi Jinping early this year spoke of “a strong currency” as one of his top priorities, as part of plans to strengthen the country’s status as a financial superpower. A depreciation of the renminbi would have enormous consequences for global trade and potentially increase tensions with Washington by increasing the competitiveness of Chinese imports to the US.
How China Manages the RMB
Every day the authorities calculate a central rate against the US dollar, also called the fixed rate. Traders view this rate as an important tool to communicate central bank policy guidelines.
The market exchange rate may fluctuate within plus or minus 2 percent of the fixing rate. This is known as the band.
Authorities have a wide range of formal and informal tools to intervene and keep market interest rates within the range, including mobilizing cash in state-owned banks to defend the yuan. China has tried to allow more flexibility in the exchange rate, adjusting the fixing rate over time to reflect market pressures.
Recently, however, interest rate setting has remained unusually stable, even though market rates are close to the weaker end of the range. That suggests there are depreciation pressure about the RMB that the authorities are opposing.
High interest rates in Western economies – especially in the US – have recently led to an even sharper decline in other Asian currencies against the dollar.
While the yuan has weakened about 2 percent against the U.S. dollar this year, the Japanese yen has fallen more than 11 percent and the Korean won has fallen more than 5 percent. Both are trade competitors with China.
Analysts are divided on which direction the Chinese currency will move next.
“The yuan is still dominating the market for now,” said Tiffany Wang, a China currency and interest rate strategist at JPMorgan, with many investors pointing to the gap in interest rates.
While the U.S. Federal Reserve is expected to start cutting rates later this year, “a shallower rate cut this time will keep U.S. rates above China’s for the foreseeable future,” she said.
The PBoC has said it wants to keep interest rates low or cut them if necessary, in response to continued weakness in China’s economy following the coronavirus pandemic and a real estate market crisis.
Some traders, meanwhile, believe the yuan could suffer if Donald Trump wins the US presidential election in November and raises tariffs on Chinese goods.
IMF First Deputy Managing Director Gita Gopinath urged Beijing at an event on Wednesday to consider allowing more flexibility on the exchange rate, saying this would “reduce deflation risks and prevent external shocks would help absorb”.
However, despite market pressure, the PBoC has not signaled any plans to change course.
In its latest quarterly monetary policy report earlier this month, the central bank said it would “decisively correct procyclical behavior in the foreign exchange market and protect against the risk of an over-adjustment of the exchange rate.”
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Kevin Liu, head of offshore China and overseas strategist at CICC Research, said it would send a mixed signal if China were to weaken the yuan even as it increases central government investment in an effort to boost growth. The recent issuance of long-term bonds should provide a “positive catalyst” to support the yuan, he said, as more central government spending should support the economy in the medium term.
Simply from a trading perspective, the yuan is not overvalued, said Chen Long, co-founder of Plenum, a Beijing-based consultancy.
“China’s export growth has been strong, and under such conditions the renminbi tends to appreciate against the US dollar,” Chen said.
Still, the PBoC’s reluctance to allow the yuan to weaken against the dollar is a marked departure from its previous policy of following a basket of currencies. That has left the central bank uncomfortably exposed.
One currency trader at a state-owned bank in Beijing said monetary authorities are wondering how to ease pent-up market pressure on the yuan, such as by allowing a gradual weakening of interest rates. Traders at Citic Securities believe the central bank could slowly weaken rates to 7.11 to 7.12 per dollar in the coming weeks, while avoiding sharp moves.
The PBoC did not respond to requests for comment.
Additional reporting from Joseph Leahy in Beijing