A trade weighted index looking at the value of China’s yuan climbed to a five-year high last week, and analysts expect the currency to remain at elevated levels in the foreseeable future as the government allows greater flexibility and tries to remove distortions in the economy.
A simulated CFETS RMB basket index, which measures the yuan’s value against a number of foreign currencies, climbed to 98.70 on Friday, marking its highest level since March 2016, according to the China Foreign Exchange Trading System & National Interbank Funding Centre (CFETS), which is a sub-institution directly affiliated to the People’s Bank of China.
The strength in the yuan’s value was largely driven by China’s large current account surplus in the past year, which in turn has been boosted by the nation’s strong export performance and rising trade surplus.
Beijing’s liberalisation policies have also accelerated capital inflows into its equity and bond markets, helping to support the yuan, according to Chen Dong, senior Asia Economist at Pictet Wealth Management.
What the government did was simply to make it easier for global investors to access its markets. That was an important move and so we saw a huge rise in portfolio inflows into China
“Chinese capital markets are simply too big to ignore,” said Chen. “What the government did was simply to make it easier for global investors to access its markets. That was an important move and so we saw a huge rise in portfolio inflows into China.”
In 2015, the PBOC imposed harsh capital controls, squeezed interest rates and burned through nearly US$320 billion of its foreign currency reserves to support the yuan’s value to quell market panic after a sharp decline in the stock market and an unexpected devaluation of the yuan.
The financial meltdown was sparked by a devaluation in the yuan by nearly 3 per cent against the US dollar in two days and the government’s crackdown on margin-financing activity in equities.
But in recent years, the PBOC has been relaxing its capital account to internationalise the yuan in a controlled way through market access programmes such as the Bond Connect, Stock Connect and Wealth Management Connect scheme with Hong Kong. It is also expanding the quota for the Qualified Domestic Institutional Investor and Qualified Domestic Limited Partnership programme.
“The strategic importance of yuan internationalisation is much more pronounced today because of the ongoing US-China tension, and potential financial decoupling, ” added Chen. “So [China] needs an independent currency to reduce their dependence on the US dollar system, and we actually see an acceleration of capital markets opening.”
The relatively attractive yields of China’s onshore bonds and ongoing inclusion in global bond indices has resulted in a significant increase in interest from investors from all over the world.
The Global Public Investor survey, published annually by the London-based OMFIF think tank, showed 30 per cent of central banks plan to increase their reserve holdings of yuan over the next 12-24 months, compared with just 10 per cent last year.
In stark contrast, 20 per cent of central banks plan to reduce their holdings of the US dollar over the next 12-24 months and 18 per cent plan to reduce their euro holdings.
As part of efforts to internationalise the yuan, China is increasingly moving towards free capital movement and a more flexible yuan exchange rate.
The CFETS RMB basket index was established as part of the yuan exchange rate formation mechanism to move toward a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies, reducing the importance of the yuan’s link to the US dollar.
Chen said that since the yuan’s devaluation and its reform towards a market-driven currency in 2015, the performance of the currency started to exhibit characteristics of those in more stable, developed economies, rather than of emerging markets, reducing the likelihood of massive capital flight leading to a potential financial crisis.
Compared to the last round of high capital outflows in 2015-16, foreign investors now hold six times the amount of liquid onshore securities at 7.4 trillion yuan (US$1.1 trillion), including 3.6 trillion yuan in equities and 3.8 trillion yuan in bonds, said Becky Liu, head of China macro strategy at Standard Chartered Bank.
if the yuan remains fixed to the dollar, it becomes distorted and invites risky speculation. This does not support the desire to hold the yuan in the long term
Jianwei Xu, senior economist at Natixis, said that the PBOC’s decision in 2015 to allow greater flexibility in the yuan’s movement was actually an important factor to instil inherent confidence in the yuan, removing the likelihood of a sharp, sustained decline in the currency.
The internationalisation of the yuan will hinge on confidence in the currency rather than short term appreciation and depreciation against the US dollar, Xu said.
China’s global financial position, which shows it remaining as a net exporter of capital, allows policymakers to be more oriented, according to HSBC. China’s net international investment has risen to US$2.1 trillion from US$1.7 trillion in 2011, providing stability to the economy.
“In the future, a more market-driven yuan will be increasingly used by other Asian economies as China’s influence rises,” Xu said.
“What is best for investors is a more flexible currency that reflects the market environment. In contrast, if the yuan remains fixed to the dollar, it becomes distorted and invites risky speculation. This does not support the desire to hold the yuan in the long term.”
Jason Liu, head of CIO Office Asia-Pacific at Deutsche Bank International Private Bank, said the PBOC also has ample measures and experience to ensure the yuan’s stability in case of a sharp depreciation and capital outflow pressure from an escalation of US-China tensions.
The PBOC could reintroduce countercyclical factors into its calculation of the yuan’s allowable daily trading range to manage the short-term one-sided moves of yuan. It could also implement some administrative measures to limit the amount of yuan that residents’ can exchange into US dollars, Liu said.
The PBOC sets a daily reference rate for the yuan against the US dollar, which forms the centre of its allowable trade range for the day and reflects its intention for the currency. The yuan is allowed to rise or fall by 2 per cent on either side of the daily parity, which the PBOC often uses to signal to the market its stance for the currency.
The monetary policy committee’s quarterly statement last month reiterated the PBOC’s pledge to deepen the market-oriented reform of the exchange rate, boost the flexibility of the yuan and to maintain its value basically stable at a reasonable and balanced level.
However, reforms of market-driven interest and exchange rates have not yet been completed, said Zhang Ming, deputy director of the Institute of Finance at the Chinese Academy of Social Sciences.
Because of this, Zhang believes there remains speculative demand-driven characteristics from onshore and offshore arbitrage activities behind the internationalisation of the yuan, rather than solid demand for its use.
The fundamentals behind the yuan appreciation will become much less supportive as the difference between the more favourable yield now on offer in China start to shrink as the rest of the world economy recovers and the US Federal Reserves begins to tighten its monetary policy, creating challenges for the PBOC to manage market expectations for the yuan.
Although the share of the yuan in global official foreign exchange reserves has repeatedly hit record highs, it cannot compete with the US dollar and the euro in terms of trade, finance, or commodity transactions, added Zhang, who is also deputy director of the National Finance and Development Laboratory.