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China’s yuan is hovering at its weakest level against the dollar since the 2008 financial crisis, and analysts expect the yuan’s strength to be further tested in the coming weeks as China’s recovery from the outbreak slows.
The yuan has fallen more than 5 percent against the dollar this year, touching 7.29 per dollar, just off last year’s high of 7.32, the yuan’s weakest level in 15 years.
In recent weeks, the yuan’s slide has prompted the People’s Bank of China to step up protections for the currency.
But even if the PBOC succeeds in crowding out investors who are betting on a further decline in the yuan, policymakers in Beijing still face a battle to revive the currency. Here’s the dynamic in play:
Why is the RMB under pressure?
China’s economy has not bounced back as expected after lifting a three-year lockdown. Concern about its performance is enough in itself to encourage shorting the yuan.
But those problems have been magnified by defaults on payments by struggling property developers and massive debt maturities in local government debt. China has been cutting key interest rates to stimulate demand.
Anemic growth in China and the corresponding rate cuts have resulted in a large divergence between Chinese government debt yields and U.S. government debt yields.
U.S. interest rates are at 22-year highs, but that hasn’t completely wiped out inflation, nor has it pushed the economy into recession. More attractive U.S. interest rates have sparked outflows from China’s yuan-denominated bond market.
Chinese exporters also convert a smaller percentage of their dollar revenues into yuan, which Goldman Sachs analysts said was “probably due to yield-seeking behaviour,” as dollar-denominated securities have been shown to return more than those denominated in domestic currencies. Securities are more profitable.
A weak economy and a weakening exchange rate put the PBOC in a delicate position.
“The People’s Bank of China is a bit of a dilemma as it may need to cut rates further to stimulate demand, but that would lead to another weakening of the currency,” said Mansur Mohiuddin, chief economist at Bank of Singapore.
Why is Beijing worried about capital flight?
While a weaker yuan would boost Chinese exporters by making it cheaper for other countries to buy goods, policymakers are wary of letting the yuan fall too far and too quickly.
“From a central bank perspective, the real concern about currency weakness is capital flight,” said Adarsh Sinha, co-head of Asia FX and rates strategy at Bank of America Corp.
That risk was on stark display in 2015, when a one-off devaluation by the People’s Bank of China led to massive outflows and forced the central bank to spend hundreds of billions of dollars to prop up the yuan.
Policymakers have since introduced stricter capital controls to limit capital outflows. They also turn their attention to managing movement speed in either direction, rather than defending absolute levels. The approach has proven effective in a series of subsequent periods of weakness, including 2019 amid U.S.-China trade tensions and last year’s economic disruption caused by Covid-19 lockdowns.
How is Beijing fighting back?
Analysts say China’s biggest problem is that there is no room for maneuver. “The People’s Bank of China is already using most of its tools to keep the yuan stable,” said Ken Cheung, chief Asia FX strategist at Mizuho Bank.
The central bank’s greatest weapon is its control over the onshore trading range of currencies. Every morning, before China’s domestic foreign exchange market opens, the People’s Bank of China sets a midpoint that allows the yuan to trade 2% against the dollar in both directions. Typically, the figure is adjusted to reflect changing market expectations and overnight moves in the less regulated offshore yuan.
But over the past month, the midpoint has been fixed at a level well above market forecasts, with the central bank at one point setting interest rates by a record 0.1 percentage point above market forecasts – a blow to speculators shorting the currency Clear warning.
China’s state-owned banks are helping to enforce the warning on behalf of the People’s Bank of China, sucking up yuan and dumping dollars in the onshore market. They are doing the same in offshore markets to ensure rates don’t deviate too far from the Chinese market’s close.
And, for the first time since 2018, state-owned banks squeezed liquidity in the offshore renminbi forward market, a sign of how uneasy policymakers are about the pace of the depreciation.
Lenders have been selling dollars and buying renminbi in the offshore spot market, while buying dollars and selling renminbi in the short-term currency forward market. The strategy makes it more expensive for currency traders in Hong Kong, London and New York to short the currency.
One measure that Chinese authorities have yet to redeploy are informal restrictions on foreign exchange transactions in the country’s interbank market. Those restrictions were lifted last September amid a surge in outflows from yuan-denominated bonds, largely as global investors dumped Chinese government debt for higher-yielding U.S. Treasuries.
How low can the exchange rate be?
Analysts are lowering their forecasts for the currency against the dollar. Goldman Sachs recently lowered its three-month forecast to 7.3 yuan per dollar from 7.2 yuan — a level it briefly breached this month.
Societe Generale’s forecast was more pessimistic, revising its year-end forecast from 7.4 yuan to 7.6 yuan. That would imply a drop of more than 10% in 2023, the biggest annual drop on record since China abandoned its soft peg to the dollar in 2005.
“They can’t simply disconnect the fixing from fundamentals,” Kiyong Seong, chief Asia macro strategist at Societe Generale, said of the PBOC’s restrictions on exchange rate controls. “In the medium term, they’re going to have to let The solution moves to the market level.”