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The yuan’s trajectory has taken analysts and policymakers by surprise

Value Judgments

Money can be as unpredictable as the weather. On September 12, 2017, the Chinese yuan finally fell a little against the US dollar in terms of the benchmark central parity price set by China’s central bank each trading day.

By NewsChina Updated Oct.1

Money can be as unpredictable as the weather. On September 12, 2017, the Chinese yuan finally fell a little against the US dollar in terms of the benchmark central parity price set by China’s central bank each trading day. The yuan had risen each trading day since August 29, the longest period of unbroken growth since July 2005 when the parity price setting system was launched, and the highest point since May 12, 2016. 
Also on September 11, the yuan dipped on the onshore interbank market and the offshore market. This was attributed to the relaxing of foreign exchange rules imposed on Chinese banks and foreign financial institutions nearly two years ago. The rules were part of China’s efforts to resist strong depreciation pressure on the yuan at that time. As China’s central bank explained, the decision to ease these rules was based on a consensus among academics and the market that the yuan’s rate stood at a “reasonable equilibrium,” with cross-border capital flows and market demands for foreign exchange “more balanced.” The market picked up the hint that the Peoples’ Bank of China (PBOC)had changed its attitude out of concerns over the yuan’s rebound this year being too fast and too strong.  

Yuan price and policy changes over the past two years are widely believed to be the result of variants of the US dollar against other major currencies beyond the yuan, as well as China’s domestic situation, including economic growth and foreign exchange measures. There were surprises along the way.  

Yuan’s Rally   

The yuan has been gaining ground this year. Its monthly average benchmark parity price in August reached a 10-month record as a result of accelerating appreciation since the end of May. This is the opposite of what analysts expected at the end of 2016, when rounds of depreciation triggered pessimism about the yuan’s future performance.  

The situation also represents the reversal of a pattern that stretched through the decade to the second half of 2014. The yuan began to face great appreciation pressure immediately after the daily official parity price was introduced in 2005. The surplus of China’s international payments, generated by China’s trade surplus, inbound foreign direct investment and short-term capital inflows, boosted the yuan’s value. The US and EU believed the yuan would have been even stronger than it was had the Chinese government intervened less to resist this appreciation. The yuan’s value had been a flashpoint between China and its two largest trading partners, the US and the EU, for years. They complained that the yuan was undervalued to give Chinese exporters an unfair advantage. During his election campaign, then-US Presidential candidate Donald Trump threatened to label China a “currency manipulator” on the first day of his presidency.  

He never followed through. Instead, the Trump administration has come to welcome China’s intervention on the yuan. In its April 2017 report to the US Congress, “Foreign Currency Policies of Major Trading Partners of the United States,” the US Treasury Department recognized that China’s recent intervention had “sought to prevent a rapid RMB depreciation that would have negative consequences for the United States, China, and the global economy,” though it reiterated the criticism of China’s intervention on the yuan in previous years. In 2015 and 2016, China’s yuan weakened by 5.8 percent and 6.8 percent against the US dollar respectively. It is widely held that the yuan would have plunged further had the Chinese government not intervened.  

The return of the yuan to strength in 2017 has already affected China’s foreign trade. According to China’s General Administration of Customs, the first eight months of 2017 saw China’s exports increase at only around half the rate of imports, and China’s trade surplus shrank by 15 percent year on year. 

Dollar Dips 

The benchmark for the dollar’s value on the international market, the ICE US Dollar Index Futures, USDX or DXY, weighted by six currencies not including the yuan, fell by more than ten percent in the year to September 12. This was the opposite of what analysts expected at the end of 2016, when the index had been on an upward track for four years in a row. The DXY soared 13 percent in 2014, the biggest growth since 1997, and stood well above 90 at the end of 2014, a rate it had not reached since July 2009. During this period the dollar was supported by a rapid recovery in US growth, the expectation for the Fed’s interest rate increase and Trump’s pro-growth commitment during his election campaign. By contrast, the European economy was overshadowed by the Brexit referendum and uncertainties in the French presidential election. The Euro accounts for more than 50 percent of the six currencies in the US Dollar Index and is the most traded currency with the US dollar on the international foreign exchange market.  

The dollar began to run out of steam in January 2017. Market confidence in sustained growth and the relief of political tension in the US dwindled. US economic data for the first half of the year undershot government targets and market forecasts. Hope that Trump would deliver his campaign commitments, including tax cuts and infrastructure spending, looked shaky at best. During the annual conference of central bankers and economists at Jackson Hole, Kansas, at the end of August, the US Federal Reserve Chair Janet Yellen refused to give any hints about the future direction of monetary policy. More recent hurricanes in the Atlantic would further dent US growth. In the eyes of analysts and the market, an interest rate hike from the US Fed within the year is less likely than it was before. Low interest rates are not attractive to capital inflows that would boost the US dollar. By comparison, the eurozone has been performing so well that the market has had a close eye on an expected European Central Bank increase in interest rates. Emmanuel Macron defeated the far-right candidate Marine Le Pen in the French presidential election, and as a result, the euro has been gaining ground against the US dollar through 2017, dragging the DXY down constantly. 

In addition, in an interview with CNBC on August 31, US Treasury Secretary Steven Mnuchin expressed support for a weaker dollar saying it was “somewhat better” for US exporters. The US Dollar Index fell after his remarks. Before this, President Trump had repeatedly expressed a lack of interest in a strong dollar.  

Technical and Environmental Change 

Chinese officials and analysts agree on the basic forces behind the yuan’s movements over the past two years, starting with depreciation and marching towards appreciation. The value of the US dollar compared with currencies other than the yuan weighs a lot on China’s new policy of setting the yuan’s parity price against the US dollar, though the extent of its impact has been contested among Chinese policymakers and analysts. Since the end of 2015, aside from the closing price of the previous trading day, the index of a basket of currencies (which has expanded to 24 currencies from 13 as of January 2017), has adopted into its formula the yuan’s parity price against the US dollar. This means the value of the dollar against other major currencies is also taken into account. China’s central bank has explained that the purpose is to guide the market to pay more attention to foreign currencies other than the US dollar. However, in this equation, to maintain the basic stability of the basket, the yuan’s central parity price needs to depreciate against the US dollar when the US dollar gains strength against other currencies, and appreciate against the US dollar when the dollar index falls.  

China’s economic situation is a factor. For example, as mentioned above, on August 11, 2015, China’s central bank declared that the closing price of the previous trading day on the inter-bank foreign exchange market would be factored into the official parity price. This was designed to move the yuan’s foreign exchange rate to a more market-oriented mechanism, as the closing price was the result of market trading. The central bank depreciated the parity price the first day of the new policy. However, as China’s economy had been slowing down for some time and coping with the aftermath of a stock market crash that year, the action was interpreted by the market as proof that China’s economy was actually worse than official data showed, and thus needed to be saved by depreciating its currency. The pessimism towards China’s growth then triggered the yuan’s nosedive right after the new policy was adopted. Some scholars regarded this as a well-intended reform taken at the wrong time. The yuan continued its trend of weakening in the following months while growth remained lukewarm.  

In 2017, China reported higher than expected GDP growth and corporate profits for the first half of the year. This provided the springboard for the yuan’s rebound. As the yuan began to strengthen, exporters who had hoarded US dollar-denominated revenue decided to switch this revenue into the yuan for fear that the dollar would depreciate further. Their sell-off further weakened the dollar. This was regarded as an increasingly significant factor after May when the yuan’s rebound firmed up. 

In addition, China has stepped up its crackdown on irregularities, particularly unregulated loans that could threaten the nation’s systemic financial security. This has reduced market liquidity and pushed market interest rates higher than the interest rate in the US. It may also have encouraged capital inflows into China, boosting the yuan. 

Sentiment Hedge  

Another important variable is Chinese measures to hedge market sentiment when it is regarded as erratic by Chinese foreign exchange authorities. At the end of May 2017, China’s central bank adopted a new variable called “countercyclical factors” in its calculation of the parity price. According to a statement by the China Foreign Exchange Trade System (CFETS) run by the central bank, this is designed to offset lopsided market sentiment that might trigger irrational “herd behavior.��� The new variable is thought to have played a big role in the accelerating growth of the yuan since the end of May.  

During its period of devaluation, China also spent its foreign exchange reserves to prop up the yuan. The reserves dropped month by month between July 2014 and February 2017, decreasing by nearly a trillion US dollars during this period. Pan Gongsheng, deputy governor of the People’s Bank of China (PBOC) and head of the State Administration of Foreign Exchange (SAFE), lamented in the early July issue of the Qiushi Journal, the flagship twice-monthly magazine of the Central Committee of the Communist Party of China, that the money had been spent by Chinese companies and citizens on their overseas investments, foreign debt repayments and overseas travel. However, the market and analysts doubt this. Dr Xiao Lisheng, deputy head of International Finance division of Institute of World Economics and Politics of the Chinese Academy of Social Sciences, argued in a July opinion piece for Caixin that the money had been mainly used by China’s foreign exchange authorities to stabilize the yuan’s rate when it was hit by capital flight. 

The issue of capital flight has been a contentious topic since China began to weather the yuan’s constant depreciation in the second half of 2014. China has tightened capital controls since then. The efforts have been recognized as a major contributor to the yuan’s rebound this year. While dwindling foreign exchange reserves may ordinarily be far from the minds of the average Chinese citizen, changes in policies towards capital flows have a direct impact on Chinese companies, investors and consumers who have been increasing their overseas ventures rapidly during this period. As such, the policy has captured the attention of both analysts and the public. 

In an August article for China Forex, a biweekly SAFE publication, SAFE spokesperson Wang Chunying, who heads the Balance of Payments Department, said the pressure of capital outflows from China had been eased significantly, as shown by several major indicators including the rebound of the country’s foreign exchange reserves, less sales of foreign exchanges and the decline in outbound foreign direct investment.  

The effects of currency depreciation always vary among stakeholders. However, a mix of currency depreciation and capital outflow, which reinforce each other, create the worst circumstances an economy can experience. This is one of the bitterest lessons that the world has learned from recurrent regional and global financial crises. It was also China’s major concern in the face of the yuan’s depreciation, which has been reversed now but may come back due to uncertainties around the growth of China and the US. More importantly, the reasons for and results of China’s recent efforts to curb excessive capital outflows go beyond the yuan’s movement.