Forex Comment Jan 06

China puts brakes on strongest yuan in 30 months

The People's Bank of China has undertaken two moves to slow the rise in the value of its currency to 'promote two-way balanced flows of cross-border funds'; analysts expect it to trade in the mid to low 6s this year

China puts brakes on strongest yuan in 30 months
Image: Reuters.

(ATF) Beijing has raised the quota for domestic firms giving overseas loans and said it will relax the rules on cross-border yuan use – two moves that analysts say will cool the strengthening of the yuan, which has rallied to a 30-month high against the greenback.

China's central bank raised its macro prudential adjustment coefficient for domestic firms, giving overseas loans from 0.3 to 0.5, which will increase the upper limit of such loans, according to a statement posted on the website of the People’s Bank of China (PBoC) on Tuesday evening.

The move will help meet Chinese companies' demand for capital when they expand their business overseas, help expand cross-border use of the Chinese yuan, as well as “promote two-way balanced flows of cross-border funds”, the central bank said.

The adjustment came on the heels of another policy announced on Monday, which will make it easier for individuals, investors and companies to settle transactions in yuan internationally.

The new rules, which take effect on February 4, will facilitate yuan trade settlements, simplify paperwork, and make it easier for foreign companies to invest in China using yuan that they earn, according to a circular jointly released by the PBoC and five other government agencies.

Strongest yuan in 30 months

The relaxations were announced as the yuan continued to strengthen at the start of the new year after appreciating 6.3% in 2020, and 8.5% over the second half of last year.

On Tuesday, the yuan-dollar midpoint set by China's central bank rose about 1% to 6.4760, the biggest change since China abandoned a dollar peg in 2005, reaching the highest level it has been since June 2018.

Wan Yijing, an analyst from Galaxy Futures, said that the Comprehensive Agreement on Investment reached last Wednesday between the European Union and China was a new factor boosting the strength of the yuan, as well as the healthy economic recovery and weakness of the US dollar. 

The EU-China trade pact was followed by a PBoC announcement at the weekend that it would increase the influence of the euro in determining the currency's daily midpoint fix at the expense of the dollar.

On Wednesday though, the central bank set its fix at 6.4604 per dollar, 0.06% weaker than the average estimate in a Bloomberg survey. The offshore yuan erased a gain and the currency traded onshore declined for the first time in three days after the rate was released.

Encouraging yuan outflows

Increasing the upper limit for overseas loans will help Chinese firms with multinational operations to provide more financing support to affiliates or subsidiaries overseas, while the new policy on cross-border yuan use will encourage these firms to make loans in yuan instead of foreign currencies, Wang Youxin, a researcher at the Bank of China's research institute, said.

Tang Jianwei, an economist at the Bank of Communications, said the policies would facilitate outflows of capital in yuan and help ease the appreciation pressure on the currency.

Despite Beijing’s moves to slow the gain by the yuan, most analysts expect it will continue to rise, because of the economic recovery.

"The latest moves are a catch-up with the other dollar pairs which have weakened recently, but we expect this to continue and the yuan to strengthen,” Patrick Bennett, a strategist at CIBC, told ATF.

“This will accurately reflect an economy which is outperforming and offers yield, growth and asset appreciation. We see the yuan appreciating to low 6s in the current year which means an 8-10% appreciation. Long-term it could go sub-6 and trade with the 5 handle,” he said.

Tang, from the Bank of Communications, had a more conservative outlook on the yuan, expecting the pace of appreciation to slow this year with movements between 6.3 and 6.7.

Wan, from Galaxy Futures, also expects the yuan to appreciate in a more controlled manner this year, citing Beijing’s proposal at last month’s Central Economic Work Conference to “deepen market-oriented reforms of the interest and exchange rates while keeping yuan exchange rate stable within a reasonable range”.

Higher volatility

On the other hand, Beijing will push for further internationalization and freer conversion of the currency, an agenda that is expected to speed up and may cause higher volatility of the yuan in 2021, Wan said.

In addition to relaxing the rules on cross-border yuan use, the central bank’s push for an official digital currency is also seen as an attempt to internationalize the yuan across different countries. 

Shenzhen recently announced large-scale “red envelope” testing of the digital yuan, gifting 100,000 residents with 200 yuan each to spend, amid national plans for the new currency to be widely available before the 2022 Beijing Winter Olympics.

Yuan to compete with dollar 

As more dollar-driven crises emerge in developing countries, it is possible that the yuan will emerge as an alternative and compete with the dollar, a shift that analysts say will only be strengthened by the efficiency promised via its digital form.

“Digital currency is another force which promotes less reserve holding of the US dollar, as it is a more efficient way of transfer of money and will expedite the use of the yuan. As we see more trade settlements in yuan, central banks buying and capital controls being eased, the dominance of the dollar as [the international] reserve currency will be eroded by the yuan," Bennett said.

While a stronger yuan coupled with the opening up of the domestic capital market will help attract foreign capital, Beijing also worries about the potential for asset bubbles and risks posed to the domestic financial system. An expensive yuan would also make Chinese goods more expensive to buy for customers overseas, potentially hampering China's export receipts.

The measures that Beijing has taken over the past few months indicate the policy-makers intend to prevent excess volatility and an overheating of the dollar-yuan exchange rate.

China’s foreign exchange regulator resumed allocating quotas for the Qualified Domestic Institutional Investor scheme in September after a pause of two years and five months, a move that should encourage capital outflows, putting downward pressure on the yuan.

In addition, the central bank announced in early October that banks were no longer required to set aside reserves when purchasing foreign currencies for their clients through foreign exchange, a move interpreted as an attempt to boost dollar buying and put the brakes on the yuan rally.

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