China’s yuan rally fuels central bank debate on using currency appreciation to fight commodity price surge

·5-min read

The rally in China’s yuan in the past month has fuelled a public debate among central bank officials on whether China should tolerate greater appreciation of the yuan to help combat surging commodity prices and imported inflation.

After slipping against the US dollar for the previous four months, the yuan began to rebound in April. On Wednesday, it was changing hands at around 6.40 per dollar after briefly surpassing that level on Tuesday for the first time since June 2018. A lower US dollar-yuan figure indicates a stronger Chinese currency, since it takes fewer yuan to buy one dollar.

Last week, Zhou Chengjun, the director of the People’s Bank of China (PBOC) Finance Research Institute, said China has to eventually give up its control over the currency’s exchange rate if it wants to achieve greater global use of the yuan.

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Lu Jinzhong, head of research at the PBOC’s Shanghai branch, also wrote last week in the PBOC-run magazine China Finance that a stronger yuan could help offset rising commodity prices and prevent imported inflation.

US dollar-yuan exchange rate: what is it and why is it important?

Ju Wang, senior currency strategist at HSBC, said Zhou’s comment was “a reiteration of China’s long-term foreign exchange policy goal, while the second article [by Lu] represents a policy debate on how the exchange rate should react to external shocks”.

“We agree with the former in the long run, and believe the latter is up for debate given that this round of commodity price surge is not fully due to demand from China,” Ju added.

To dampen speculation that China was launching a full-fledged liberalisation on capital flows into and out of the country, PBOC vice-governor Liu Guoqiang said on Sunday that the existing managed floating exchange rate system remained “an institutional arrangement fit for China at present and in the foreseeable future”.

The theory of using yuan appreciation to contain imported inflation is less clear-cut since it could hurt manufacturers by reducing the price competitiveness of their exported goods – meaning the costs could offset the benefits, according to Tommy Xie Dongming, an economist with OCBC Bank in Singapore.

Nevertheless, analysts have predicted that the yuan should continue to strengthen this year because of its yield advantage over the US dollar, and given that the pandemic situation in other developing Asian countries has continued to worsen, diverting export orders to China.

While commodity prices could peak in the third quarter, risks are rising for the yuan to make a clean break above the 6.40 per dollar threshold because of broad dollar weakness and because of the approaching celebrations surrounding the Chinese Communist Party’s 100th anniversary in July, said Gao Qi, currency strategist at Scotiabank.

China’s major state-owned banks were seen on Tuesday afternoon buying US dollars at around the level of 6.40 yuan each, in an apparent move to try to slow the yuan’s appreciation, Reuters reported, citing four unidentified sources.

The PBOC has been letting the market determine the yuan’s exchange rate because demand and supply flows remain balanced

Li Liuyang, China Merchants Bank

China’s major state-run banks often act as agents for the PBOC, the central bank, which had until recently intervened directly in the foreign exchange market through US dollar purchases or sales. In the past few years, the PBOC has largely stepped back from intervening in the market, occasionally using bank proxies to help smooth excess fluctuations of the currency.

“The PBOC has been letting the market determine the yuan’s exchange rate because demand and supply flows remain balanced,” said Li Liuyang, chief currency analyst at China Merchants Bank. “But it did not say it would completely give up its control, in case of situations of extreme volatility.”

Moreover, China is offsetting yuan-appreciation pressure by shifting towards a policy of macroprudential supervision to bring about adjustments of cross-border flows by banks and corporations. New financial regulations were introduced early this year to encourage more yuan outflows while curbing borrowing that is repatriated onshore.

China moves to curb yuan rally pressure due to hot money and export concerns

China is also opening up its financial markets as it manages cross-border investment flows through new market access programmes such as the Bond Connect, Stock Connect, Wealth Management Connect, Qualified Domestic Institutional Investor and Qualified Domestic Limited Partnership schemes.

While the global uptake of the yuan eased in April after nine straight months of increases, this was only a transitory setback, said Kelvin Lau, senior economist for Greater China at Standard Chartered Bank.

Data from the Institute of International Finance shows that emerging-market securities attracted around US$45.5 billion from non-resident portfolio flows in April – the highest total in three months, mainly supported by China flows: US$4.8 billion into China’s debt market and US$13.5 billion into Chinese equities.

“Resumption of yuan appreciation and [mainland-bound] portfolio flows bode well for [yuan usage] in the coming months,” Lau said.

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