Yuan rally headed for correction

The yuan will remain strong against the US dollar for a while, but chances of a correction of the Chinese currency are also increasing in the long run as China’s economic recovery is expected to lose steam, and Beijing has moved to rein in the surging yuan, analysts say.

The broad dollar weakness and capital inflows pushed the onshore yuan to a three-year high on May 31, before retreating to 6.4092 per US dollar on Friday on concerns that Beijing may roll out more measures to cool the yuan rally.

The People’s Bank of China last week asked lenders to hold more foreign currencies in reserve by raising the forex reserve requirement ratio for the first time in 14 years, a move that analysts believe will pare back the onshore supply of foreign currencies including dollars to help weaken the yuan, which has rallied for two months against the dollar. Meanwhile, big state-owned banks were seen buying US dollars to curb the yuan to breach the psychologically important 6.4 yuan per dollar level, Reuters reported. China Development Bank has also issued its first US dollar-denominated onshore bond in nearly six years, a sign that Beijing is trying to mop up the dollar liquidity onshore.

Other potential measures to slow the yuan’s rise include lifting restrictions on outbound direct investment, expanding current overseas investment schemes, and facilitating cross-border investment with more asset classes available, China Renaissance Securities analysts led by Bruce Pang Ming, head of macro and strategy research, write in a report.

Former and current Chinese officials are warning against speculative bets on the yuan. Regulators have also talked down the use of currency appreciation to combat commodity price surges.

Still, a strong yuan against the US dollar will continue in the near term, due to fundamental factors such as a weak greenback, China’s economic recovery, and current account surplus, in the run-up to the Communist Party of China centenary in July, analysts say.

With dollar seasonality negative in June and July and a non-negligible possibility of the yuan’s appreciation spell continuing ahead of the 100th anniversary of the CPC, 6.25 looks to be within reach in the next couple of months, Rohit Arora, senior emerging markets FX and rates strategist of UBS Global Research, says in a note.

China Renaissance Securities expects the International Monetary Fund to increase the yuan’s weighting in its special drawing rights basket in the 2022 review. “We believe more measures will be rolled out in the coming years to deepen China’s trade and cooperation with other countries, such as furthering the liberalization and facilitation of trade and services, as well as pushing forward convertibility and internationalization of the yuan,” Pang says.

The IMF added the yuan to the SDR basket in 2016 with a 10.92 percent weight. IMF members can exchange SDRs for freely usable currencies among themselves.

The yuan will become a global reserve currency sooner than most people expect, billionaire investor Ray Dalio told CNBC.

The yuan’s share in global currency reserves stood at 2.25 percent in the fourth quarter last year, up by 0.31 percentage point from a year earlier, while the dollar’s share slid by 1.7 percentage points to 59.02 percent, data from the IMF shows.

“We think the share of yuan will continue to rise given the rising interest in yuan-denominated assets which offer attractive yield and diversification benefit,” OCBC Bank economist Tommy Xie Dongming says. China’s digital currency, which aims to substitute the central bank’s supply of paper notes and coins, is “unlikely to be a game changer for China’s financial system,” as M0, equal to notes and coins in circulation, accounted for less than 4 percent of China’s total money supply, Xie says. “It is also premature to be worried that the digital yuan will challenge dollar dominance if it cannot even disrupt China’s own financial system.”

In the mid to long term, however, analysts do not expect the rapid appreciation of the yuan to be sustainable, given an expected economic growth slowdown in China and chances of a bounce in the US dollar if the Federal Reserve changes its ultra-easy monetary policy stance.

China Renaissance Securities expects the yuan at 6.4 per US dollar at the end of this year. “We expect a stronger dollar in the second half of 2021 with the US economy recovering and potentially weaker hot money influx to China amid a narrowing US-China spread.”

China International Capital Corporation (3908) sees limited potential for the yuan to appreciate further and warns against correction risks. “In the coming months, we expect the current account surplus to narrow as overseas production gradually recovers amid vaccinations and accelerating global recovery On the other hand, we think that China’s economic growth momentum may decelerate in the second half, because the high growth of external demand is unlikely to sustain and the recovery of domestic demand is slow amid structural divergence.”

Retail investors have flocked to yuan-denominated investments. CMB Wing Lung Bank says yuan-denominated fixed deposit e-coupons on CMBWLB Wintech mobile application had been snapped up on May 28 in a single day. Yuan deposits in Hong Kong increased by 1.23 percent to 781.95 billion yuan (HK$948.46 billion) at the end of April from a month before, according to the Hong Kong Monetary Authority.

Investors should be prudent about investing in yuan-denominated assets with low liquidity, such as mainland property, given the potential correction of the yuan, Pang says.

During the latest eight rounds of the yuan appreciation, Hong Kong-listed stocks and Chinese American Depositary Receipts outperformed A-shares, according to China Renaissance Securities. Among A-shares, telecom, healthcare, consumer staples and materials performed well during the yuan appreciation cycles, and among sectors of the MSCI Hong Kong and the Hang Seng Index, communication and industrials, financials and property outperformed, China Renaissance Securities says.

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