• Chinese yuan has rebounded against USD since COVID-19 outbreak
  • CNH and reserve requirement ratio have moved in opposite directions past 12 months after 25 years of moving in tandem
  • Export boom during pandemic lifted CNH as consumers in lockdown moved away from services sector to manufactured goods
  • Low inflation could help China ease monetary policy further even as the Fed moves to wind down asset purchases, consider rate hikes  

Over the past three years, the Chinese Yuan (CNH) has strengthened sharply against most emerging market currencies (Figure 1) while tracking closely European currencies such as the euro (EUR) and British pound (GBP). CNH fell against the U.S. dollar (USD) in the two years after the U.S. began placing additional import tariffs on Chinese goods before rebounding as the pandemic began (Figure 2).

Figure 1: China’s currency bears little resemblance to other members of “BRICS”

Figure 2: CNH closely tracks EUR and GBP in particular

In essence, CNH behaves like a developed market currency and its value closely tracks those of the chief buyers of China’s exports.  Although China’s economy is sometimes lumped into the “BRIC” category along with Brazil, Russia and India, its economy bears little resemblance to those three nations.  Unlike Brazil and Russia, China is a manufacturing center and not an exporter of commodities.  In contrast with India, China relies on heavy industry rather than services.

Going forward, there are both upside and downside risks for China’s currency.  Here are the factors that will likely contribute to movements in the exchange rate.

Monetary Policy

Like most currencies, the yuan appears to strengthen in response to tighter monetary policy and vice versa.  The People’s Bank of China’s (PBoC) primary tool for changing monetary policy is the reserve requirement ratio, which it adjusts more frequently than it does interest rates (Figure 3).  Over the past 25 years, CNH has tended to strengthen versus USD following increases in PBoC reserve requirement ratio and has tended to fall versus USD after periods in which PBoC relaxes the ratio (Figure 4).  

Figure 3: The reserve requirement ratio has been PBoC’s most frequently used policy tool

Figure 4: CNH has often moved with the reserve requirement ratio but has diverged recently

During the past 12 months, the reserve requirement ratio and CNH have been heading in opposite directions.  The PBoC eased the reserve requirement ratio in July, yet CNH remains near its all-time high versus USD.  What appears to be pushing CNH higher is net exports.  We’ll come back to factors that might influence China’s future monetary policy in a moment, but first a word on how net exports and other factors related to the pandemic may have contributed to the recent divergence between CNH and the PBoC’s reserve requirement ratio. 

Net Exports

After dipping early in the pandemic, China’s exports began to soar last summer. Consumers in many of China’s key trading partners markets faced lockdowns and travel restrictions making it difficult to spend money on experiences such as restaurant meals and vacations.  As a result, consumer savings rates surged as did spending on manufactured goods.  As the world’s premier manufactured goods exporter, China benefitted disproportionately from this surge in demand. Imports also surged, but not to the same extent as exports (Figure 5).

Figure 5: Chinese exports soared during the pandemic, outpacing imports

Growth gaps

China’s economy has grown much faster than the U.S. economy – or for that matter just about any other economy -- over the past several decades.  However, the gap between China’s pace of growth and that of the U.S. has been anything but constant over time.  China’s pace of growth accelerated versus that of the U.S. between 2005 and 2010, and the Chinese currency rallied sharply versus USD, with its rally extending into 2013.  In 2011, China’s pace of growth began to slow, both outright and relative to the pace of growth in the U.S.  The process of relatively slower Chinese growth continued right up until the onset of the pandemic and China’s currency slid versus the U.S. dollar on and off between 2014 and early 2020. 

In early 2020, China went into lockdown before any other country, producing the only negative quarter of GDP growth in its recent history.  By Q2 2020, China was coming out of lockdown and recovering at the same moment as the U.S. economy was just starting to be severely impacted by COVID.  CNH rebounded sharply versus USD during this as the growth gap moved back in China’s favor (Figure 6).

Figure 6: CNH often follows U.S. relative growth rates with a lag

For the moment, growth gaps are difficult to read statistically.  Year-on-year growth rates are now heavily influenced by base effects – what was happening last year rolling of the fourth-quarter GDP window.  That said, the U.S. and China’s period of extreme divergence on growth rates may now be coming to an end.  Both countries are more or less in the same boat.  COVID-19 is endemic around the world.  The spread of the Delta variant remains a concern in the U.S. amid pockets of resistance to vaccinations, and has the potential to slow the country’s recovery from the pandemic. China has been able to effectively control the spread of the virus, and is more prone to further regional lockdowns to control any fresh outbreaks.  Additionally, both countries’ economies are now suffering from supply chain disruptions and higher energy costs. 

What is interesting about the growth gap is that it appears to have been a useful indicator of where CNH is going, sometimes even years in advance.

Longer-term China’s growth rate may slow for other reasons:

  • Demographics: its population growth is close to zero and its working age population is shrinking as the number of retirees rises.
  • Slower productivity growth: the rural-to-urban transition has driven China’s productivity growth over the past several decades.  That transition is now slowing and much of the low hanging fruit may have already been picked.
  • China’s economy may be overly dependent on its real estate sector.  Between 2012 and 2016 nearly 30% of China’s GDP related to real estate, according to a study by Harvard University’s Kenneth Rogoff and Yuanchen Yang. This is higher than Spain, Ireland or the U.S. during the 2000s (Figure 7).  If property development slows, it could drag Chinese growth lower.
  • Debt: China spent the past decade leveraging its economy with total public and private sector debt increasing from 140% to 280% of GDP, in line with those of the U.S. and the eurozone.  This may also imply slower growth in China going forward (Figures 8 and 9). 

Figure 8: China’s debt increase has come mainly in its non-financial corporate sector

Figure 9: China’s debt levels have converged with those of slower growing economies

Inflation and the Future of Monetary Policy

Thus far in 2021, U.S. inflation rates have been surging.  The same has not been true in Asia – at least not yet.  While South Korea’s inflation has perked up a little bit, inflation in China and Japan remain at low levels (Figure 10).  This means that in the near term, the PBoC may be able to continue easing monetary policy even as the U.S. Federal Reserve considers tightening policy by starting to taper quantitative easing as soon as later this year and possibly raising rates in 2022 or 2023.

Figure 10: Chinese inflation rates remain much lower than those of the U.S.

In the past, the PBoC has often tightened lending standards following periods of high inflation and eased them after periods of low inflation (Figure 11).  Chinese inflation is not without upside risks.  Shortages of coal and natural gas have sent prices of those commodities soaring and have triggered electrical blackouts in parts of China which could exacerbate local and global supply chain problems.  Central banks typically do not treat those kinds of supply disruptions as reasons to tighten monetary policy, however. Rather they tend to view them as being transitory.

Figure 11: The PBoC’s reserve requirement ratio often follows inflation

If China’s debt levels, real estate situation and low inflation rates convince the PBoC to continue its current course of easing monetary policy that could eventually lead to a weakening of CNH versus USD.  This might be especially true if a Chinese monetary policy easing coincides with a Fed rate hike.  Meanwhile, if consumers shift spending back towards experiences and away from manufactured items that might also slow China’s export growth, reducing the currency market’s apparent focus on net exports and refocusing attention on monetary policy to the possible detriment of CNH.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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