China’s yuan strengthens despite firming US dollar, analysts expect downward pressure next year

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The Chinese yuan strengthens supported by continued seasonal corporate demand, even as the US dollar strengthens after US President Joe Biden’s decision to reappoint Federal Reserve Chai Jerome Powell for a second term emboldening bets of higher US interest rates.

The onshore yuan hit 6.3825 per US dollar on Tuesday and prior to the market opening, the People’s Bank of China (PBOC) set the yuan’s daily fixing at 6.3929 per dollar, 23 pips firmer than the fixing of 6.3952 one day earlier.

The onshore yuan has been fluctuating around 6.38 per US dollar recently, breaking through 6.37 mark to hit the strongest since June this year on November 16.

From early July to early October, the Chinese currency fluctuated between 6.43 and 6.49 against the US dollar, with the average exchange rate at 6.47. Since mid-October, the yuan has strengthened significantly and the average exchange rate since October 20 has moved to 6.39 per dollar.

Year to date, the onshore yuan has strengthened by more than 2% against the greenback.

This round of yuan strengthening was mainly driven by robust export growth, increasing trade surplus, weakening expectations for more monetary easing by the PBOC and continued capital inflow into domestic capital market, said Wang Qian, Vanguard’s Chief Asia-Pacific Economist.

The yuan is likely to stay strong and resilient in the short-term on corporate demand, said Ming Ming, head of fixed income research at CITIC Securities. Chinese companies traditionally have greater demand for the yuan for various payments in the last two months of the year.

Some traders said they kept receiving queries from corporate clients to convert their dollar receipts into the yuan, and that this could persist until the end of 2021.

The recent appreciation of the yuan may have caused regulators’ concerns, said Zhang Yu, chief macro analyst at Huachuang Securities.

China’s Foreign Exchange Market Self-discipline Mechanism, a committee of central bank and commercial bank representatives, recently held a meeting to urge banks to limit speculative foreign-exchange trading and stay risk-neutral when trading foreign exchange for themselves and for clients, according to a statement posted on the PBOC’s website.

Banks should better track their proprietary trading and improve risk management and they are advised to conduct internal reviews when trading volumes at proprietary desks deviate significantly from the norm, it said.

The yuan’s exchange rate could strengthen or weaken in the future and two-way fluctuation will be a new normal, it said.

Notably, the statement said that “equilibrium at a reasonable level is the target and the extend of deviation and the force to correct the deviation should match.”

“That’s a new expression and it may suggest that regulators start to worry that the yuan may have deviated from anchor,” said Zhang.

However, Zhang noted that the long stretch of yuan strength “may be drawing to an end”, with monetary policy and economic growth in China and the US set to diverge in 2022.

The divergence between real GDP growth in China and the US will likely narrow to the lowest since 1989, said Zhang. According to the latest estimates by the International Monetary Fund (IMF), China’s real GDP growth for 2021 and 2022 is expected to be 5.6% and 6% respectively, while US GDP growth is expected to reach 6% and 5.2%, with growth divergence expected to narrow to 0.4 percentage points next year.

“In the long run, higher expectations for other economies to gradually raise interest rates next year and the expected falls in China’s export growth may put the yuan under pressure,” Ming said.

Wang Qian also believes that the yuan will see more depreciation pressure in the future. “China’s exports are likely to gradually weaken, in particular after supply chains recover in post-Covid era and consumer demand in developed economies shift from products to services,” Wang said.

“Meanwhile, our models show that the yield on the 10-year US treasuries remain about 30- 50 basis points lower than fair value and there is room for the US to increase interest rates, which will support the US dollar.”

He added that the PBOC is expected to further loose monetary policy to ensure stability in the financial system and lower market interest rates.