Strong Dollar Sends Yuan To New Lows, And No One Is Bothered

THE YUAN HAS fallen to a record low against the US dollar since it became internationally convertible in 2011 when Beijing allowed some overseas fund-management and securities firms to invest their yuan onshore.

This point has been coming. The People’s Bank of China has been letting the currency fall, managing only the speed of the descent with its trading band mechanism.

With inflation relatively low by world standards at 2.5% in August, China has the headroom to take the inflationary hit from a depreciating currency that makes imports more expensive. The intention is that the boost the falling yuan will give to exporters will revitalise an economy whose growth has slowed.

However, exports now account for only around 20% of the economy. A cheaper yuan will go only some of the way to offsetting the effects of zero-Covid lockdowns and a deeply troubled property market that is looking more and more like a structural, not cyclical, problem.

Raising interest rates to defend the currency would only worsen the property sector’s malaise. To the contrary, cutting them has been part of Beijing’s stimulus toolkit.

The yuan is far from the only currency to be battered by the US dollar’s strength. The euro, yen and British pound are all reeling from the US Federal Reserve’s aggressive raising of interest rates to bring down US inflation that has proved more persistent than expected.

The Federal Reserve will not abandon that policy soon. So far, US exporters have not been squealing about how the strong dollar is hurting them, as happened in the run-up to the Plaza accord in 1985. That international agreement to the US dollar led to the endaka shock to the economy of Japan, then playing the role China has recently taken as exporter to the world.

We are not at the point of a re-run of that yet. Neither China nor the United States have a short-term incentive to alter their currency’s trajectory. That point will come, but the question is whether it arrives before or after the Fed thinks it has tamed inflation.

However, just recall, a decade ago Beijing was being accused of being a currency manipulator for keeping the yuan low.

China’s Export Growth Deceleration Points To More Support For Yuan

AUGUST’S SLOWER THAN expected growth in China’s exports is another sign that the economy’s recovery is losing what little traction it had.

More policy support is likely as a consequence.

Exports grew by 7.1% last month year-on-year in US dollar terms, according to the General Administration of Customs, the slowest since April and almost half the expectation of private economists.

As much as half the growth was accounted for by higher prices, on some estimates, implying the growth in the volume of exports was even weaker than the headline number.

Imports grew 0.3% in value, down from an increase of 2.3% in July, also well below expectations.

Domestic factory output in August also contracted for a second consecutive month due to power cuts and lockdowns in response to worsening Covid outbreaks.

At the same time, weakening global demand is lessening the demand for China’s exports in most of its major markets, except Russia (up 26.5% in August, year on year).

Weaker exports will weigh on the yuan, which is close to breaching seven to the dollar, despite intervention by the People’s Bank of China.

A depreciating currency would be a boon to struggling exporters but not to domestic consumer businesses such as food and retail companies that have to bear the cost of rising commodity imports.

President Xi Jinping will be well aware of the impact on Chinese citizens as he prepares for an unprecedented third term. That implies further currency intervention as well as other measures to stimulate the economy.

CIPS Replacement Of SWIFT Will Not Be Swift

THE DECISION BY Western nations to sanction some Russian banks by excluding them from the SWIFT messaging system that underpins international bank payments will spur Beijing to accelerate the adoption of its alternative.

At its core, SWIFT is a secure messaging system, as its full name — Society for Worldwide Interbank Financial Telecommunication — implies. Thus there is no reason that its functionality cannot be replicated.

China and Russia have had rivals since 2015, the Cross-Border International Payments System (CIPS) and the System for Transfer of Financial Messages (SPFS), respectively.

However, SWIFT’s power comes from its near-universal usage by more than 11,000 financial institutions across 212 countries, conducting 42 million transactions a day on average worth some $5 trillion.

By comparison, CIPS is in its infancy. It embraces only 80 foreign banks, including some Russian ones, but most of its 1,200 participant banks are Chinese or their overseas subsidiaries.

CIPS is mainly used domestically and for transactions between Hong Kong and the mainland. There is some regional use (8% of total CIPS transactions in 2020), but take-up is marginal in Africa, Latin America, and Europe.

In 2020, CIPS handled 2.2 million payment transactions across the year, with a total value of $7 trillion. However, that represented an increase over the previous year of about one-fifth for transaction volumes and approaching one-third for values.

CIPS has been getting more policy attention since the introduction of Hong Kong’s National Security law, which heightened concern over financial sanctions from the West. This has slightly shifted the focus from CIPS’s original goal of supporting yuan internationalisation to creating a SWIFT alternative should one become necessary.

SPFS, too, is used mainly domestically, accounting for around one-fifth of domestic financial payments. However, only a handful of international banks have signed up.

Neither system is anywhere near challenging SWIFT, even though Iran, which was kicked off SWIFT, in 2019, has declared it may soon be able to circumvent Western sanctions by using a combination of the Chinese and Russian alternatives to get around its own sanctions problems.

Its optimism is based on talks between Presidents Xi Jinping and Vladimir Putin in December. According to the Russian side, the two leaders agreed to develop a joint financial messaging and clearing system that would recruit numerous international banks. That will not happen overnight.

It is not a question of building out the systems. It is getting financial institutions to use them. SWIFT has more bells and whistles than CIPS and SPFS and can be used for capital transactions. Yet they are both still clearing and settlement systems, not rocket science. They just have to be reliable, efficient and cheap.

Usage has an element of chicken and egg. As long as so few global transactions are conducted in yuan, a Chinese clearing system will not attract many foreign adopters. Yet, if the system is little used, there is scant incentive for trade to be denominated in yuan.

Further, the strong network effects SWIFT enjoys also mean high user stickiness and substantial switching costs. This Bystander has read estimates that of the banks on CIPS and SPFS, only 10% of their transactions go through one or other of the services.

SWIFT is not a dollar-based system per se or even a US entity. It can clear in 26 currencies, operates from Belgium under Belgian law, and is overseen by Belgium’s central bank.

Yet SWIFT’s geopolitical power accrues to the United States as it is one of the critical props of the dollar’s centrality as a global currency. The dollar and euro have swapped primacy back and forth as the most used currency for international payments.

Yet, at around 40% each, both overshadow the yuan’s share of barely 3%, making it difficult for China to circumnavigate the Western financial system. The dollar’s use is the root of its global influence.

China would like the yuan to break the dollar’s hegemony over international trade. It has been actively pursuing bilateral currency swaps, such as its rolling three-year arrangement with Russia so that more trade can be settled in yuan. However, even its Belt and Road contracts tend to be dollar-denominated, and the bulk of China’s international trade is conducted in currencies other than the yuan.

Once that changes, which will likely require more relaxation of capital controls, CIPS is in place to facilitate that trade. But the cart can’t pull the horse.

The Sound Of Another Trump Flip-Flop

IT IS ALL going rather swimmingly for China with the United States right now. Following the happily smooth summit between President Xi Jinping and US President Donald Trump in Florida last week, the US president has said that China is not manipulating its currency.

During his election campaign last year, Trump had repeatedly accused Beijing of artificially driving down the value of the yuan to increase its export competitiveness, and had said he would label China as a currency manipulator on his first day in office.

His about-turn pre-empts the US Treasury’s forthcoming biannual report to Congress on the foreign-exchange policy of the United States’ principal trading partners: being designated a currency manipulator by the US Treasury legally triggers US Congressional sanctions against the offending country.

In the Obama-era, the Treasury had always found a way to avoid that, but the risk to China once Trump won the election last November was acute.

Trump now accepts that China has not been manipulating its currency for a while. His need to work with Beijing on dealing with North Korea — regardless of his previous comments that the United States would take unilateral action against Pyongyang if China failed to rein in its neighbour as Washington expected — appears to have helped clarify his vision.

China Gets Its Reserve Currency Status

THE INTERNATIONAL MONETARY Fund’s executive board has, as expected, approved the inclusion of the yuan in the basket of currencies that constitute its Special Drawing Rights. Thus, China joins the dollar, euro, yen and pound sterling in the elite club of reserve currencies, as Beijing has long been so desirous of doing.

The yuan’s weight in the basket will be 10.9%, slightly less than had been expected but still sufficient to rank it ahead of the yen (8.3%) and sterling (8.1%), if a ways behind the dollar (41.7%) and the euro (31%).  The dollar’s weighting will remain unchanged: the yuan’s allocation has all been taken from the three other currencies. The new status takes effect from October 1, 2016.

The decision is largely symbolic at this point in the yuan’s international usage, but marks a milestone in the currency’s internationalization — and more significantly its full convertibility. ‘Freely usable’ is an IMF criterion for a currency’s inclusion in its basket.

As we have noted before, the contingent opening of the capital account is also an important policy priority for rebalancing the economy. The IMF’s accolade will be a boost for those in China who have been promoting that, and especially now as other economic-rebalancing reforms are flagging in the face of slowing growth and political opposition.

Christine Lagarde, the IMF’s managing director, said the decision was:

a recognition of the progress that the Chinese authorities have made in the past years in reforming China’s monetary and financial systems. The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy.

As she could have been expected to say. However, the IMF’s announcement also included this kicker:

Authorities of all currencies represented in the SDR basket, which now includes the Chinese authorities, are expected to maintain a policy framework that facilitates operations for the IMF, its membership and other SDR users in their currencies.

i.e., no backsliding of financial reform whatever the domestic temptations.

Yuan Marches On Towards Reserve Currency Status

THE INTERNATIONAL MONETARY Fund’s staff have recommended that the fund includes the yuan in the basket of currencies that constitute its Special Drawing Rights. The IMF’s board is likely to endorse the staff’s view at its November 30 meeting, agreeing that the currency meets the test of being ‘freely available’, a test that it failed in 2010 when the IMF last reviewed its basket. The yuan would then become a reserve currency from September 2016.

The staff recommendation is not unexpected, but it marks another milestone in the Chinese currency’s internationalization — and more significantly its full convertibility. As we have noted before, the contingent opening of the capital account is an important policy priority for rebalancing the economy.

Recent changes to that end, but also to address specific IMF concerns, have included overhauling how the central bank sets its reference rate for the currency in foreign-exchange markets, letting foreign central banks trade China’s onshore currency products and improving the short-term yield curve through the issuance of  three-month debt.

The People’s Bank of China said in a statement that it welcomed the IMF staff’s recommendation, trotting out that making the yuan a reserve currency would be “a win-win result for China and the world” and avowing its commitment to financial reform and opening-up.

None of that makes pushing ahead with either any less urgent, or any easier.

China’s Currency Depreciation Is Not An Opening Salvo In A Currency War

HAVING SIGNALED AS recently as late last month a widening of the yuan’s trading band, authorities have opted for a ‘one-off’ devaluation of the currency. The People’s Bank of China on Tuesday set its daily fix 1.9% lower than the previous day, its biggest daily shift since introducing the system, and taking the currency to a three-year low.

At the same time, the central bank said that future fixes would pay more heed to both the previous evening’s closing price and movements in the foreign-exchange markets. It will also seek to drive closer convergence between on- and offshore exchange rates.

This Bystander retains the view that these changes are primarily steps in the direction of eventual full convertibility of the yuan rather than a ‘currency-wars’-sparking devaluation to bolster exports and thus boost the slowing economy. Rebalancing the economy and securing IMF SDR status remain higher policy and propaganda priorities. Both require liberalised foreign-exchange markets.

As the chart above shows, the currency has been moving modestly lower against the dollar since the beginning of last year having seen a steady appreciation for the previous eight and a half years. However, as the chart also shows, the central bank has been holding a lid on that depreciation most recently, probably for fear of destabilising capital outflows.

In the short term, the central bank’s unexpected policy change will likely let the currency drift lower than it would otherwise have done. But the key point is that depreciation — and its reversal if and when it comes — will be driven more by market forces than administrative fiat.

SDRs And The Yuan’s Status As A Global Currency

MILESTONES ARE IMPORTANT markers. Case in point: the International Monetary Fund is likely to include the yuan in its currencies basket when it reviews the components of its Special Drawing Rights (SDRs) later this year.

The IMF’s determination in May that the Chinese currency is fairly valued was a straw in the wind. The Fund’s position stands in contrast with much opinion in the United States that Beijing manipulates the exchange rate to favour China’s exporters.

Once that may have been true, but no longer in any more than the most tangential way. Beijing has allowed the currency to appreciate for the past decade to get it close to ‘fair value’ through small but regular increments constrained by a daily trading band. The yuan has risen by some 25% over that time against the dollar.

That appreciation is the precursor to what may prove to be the most significant event in foreign exchange markets since the introduction of the euro. Beijing has been steadily but cautiously moving towards making its currency freely convertible and carefully opening up its capital account to that end.

That policy is also an important component of the broader policy priority of rebalancing of the economy. The yuan is now the world’s fifth most used currency, but still has a lot of ground to make up on the dollar and the euro.

To an extent, ‘internationalising’ the yuan is a potent way for China’s leaders to reflect the country’s growing power onto one of the biggest global financial markets and in doing so challenge the dollar. But it is also an inevitable consequence of the greater integration of China’s economy with the global economy.

The course of that consequence is clear: from paying for goods and services; to being a currency for global investment; and finally, the ultimate accolade, becoming a ‘reserve’ currency. 

Last year, more than 20% of China’s trade, or 6.5 trillion yuan, was settled in China’s currency. The forecast is that that proportion will pass one-half by the end of this decade. The yuan is now the world’s fifth most used currency behind the yen, pound, euro and dollar, up from 20th-most used as recently as 2011.

However, as an indication of how much ground the yuan still has to catch up, it accounts for 2% of global payments. The dollar accounts for 45% and the euro 28%. Closing those gaps will require a significant change to commodities pricing. The dollar rules that roost, especially energy contracts.

Offshore RMB clearing banks — they now exist in Canada, Qatar and Chile among half a dozen countries plus Hong Kong — are a key step in encouraging investment in yuan and greater use in trade finance. The RMB clearing banks increase pools of offshore liquidity that in turn encourage the creation of investment products.

The One Belt One Road initiative will similar boost yuan usage. The yuan-denominated loans that Beijing is making to support this infrastructure framework of overland and maritime connections to Europe will find their way back to Chinese suppliers of construction, engineering and financial goods and services. The process will repeat for providers of other goods and services such as logistics, insurance and finance as trade multiples along the new routes.

This development will mirror on a larger scale what is already happening with outward Chinese foreign direct investment, about one-third of which is now yuan-denominated.  Free-trade zones in Guangdong, Fujian and Tianjin, modeled on the one in Shanghai, will further boost this. Bit by bit, cross-border use of the yuan is being built up.

In the wake of the 2008 global financial crisis, Beijing put in place currency swaps with more than 30 other countries to ensure a rapid freezing of dollar credit markets would not again hurt its exporters. Though these, thankfully, have not been much used, they have symbolic importance for Beijing’s push to promote the yuan’s greater use in trade finance.

Just as symbolic has been the increasing willingness of other countries to start including the yuan in their official foreign-exchange reserves. The People’s Bank of China estimated that foreign central banks held about two-thirds of a trillion yuan in their official reserves at the end of April. That sounds a decent chunk of change.

However, it would be less than 2% of the total, according to this Bystander’s back-of-an-envelope calculation. That compares to 4% for the pound sterling and 23% for the euro while the dollar’s share tops 60%. It will be decades before the yuan catches even the euro.

Yuan bank deposits outside mainland China have doubled since 2013 to some 2 trillion yuan — half of them in Hong Kong. A large part of the overall increase has been speculative money riding the currency’s appreciation. That play is over, crimping the growth in deposits. However, even 2 trillion yuan is a rounding error in the global total of bank deposits.

Investors also now have a growing range of yuan-denominated instruments beyond bank deposits from which to choose. Increasingly this includes domestic bonds and equities, not just offshore ‘dim-sum’ bonds. The pilot cross-trading of Shanghai and Hong Kong equity issues, which is all yuan-denominated, has been a boom in this regard. It will continue to expand, and Shenzhen stocks are expected to join the arrangement before too long.

The concept is being applied to mutual funds, too, again initially on a trial basis. At the same time, opportunities for Chinese investors to invest directly in overseas financial markets are gradually being expanded through the qualified investors scheme.

On some calculations, China is now a net exporter of capital.

For all the aspirations of Beijing and the real progress the yuan has made towards becoming a global currency, there is still an awfully long way to go. If the IMF does include the yuan in its SDR basket, as Beijing is lobbying for so hard if so discreetly, it will nudge the Chinese currency a little further down that road, but only a little bit.

A bigger question is, how much impact such a high-profile move would have on American companies that, as a class, do not conduct international trade in any currency other than their own, let alone China’s. In a U.S. presidential election season, when some candidates will want to be seen to be ‘tough on China’, it could prompt a backlash if the debate becomes a xenophobic ’the dollar vs. the yuan’.

A further, if less likely political risk, is that the U.S. uses its veto to block a decision to include the yuan in the SDR basket. That would be a confrontational move, far beyond Washington’s passive but notable absence from any support for any of the moves Beijing has made to expand the international use of the yuan.

Beijing has made a commitment to liberalise fully its capital account by the end of this year, and thus, to all intents and purposes, to the yuan being fully convertible. The economic reformers see that as a stepping stone to further opening of China’s domestic markets to foreign capital that will be necessary for overall economic rebalancing. There are vested interests that oppose full convertibility for just that reason.

China Doubles Yuan’s Daily Trading Band

CHINA’S DOUBLING OF the daily trading band within which its currency can move is another cautious step towards letting market forces play a larger role in the economy. The People’s Bank of China says the exchange rate will be allowed to move 2% above or below the midpoint range it sets each day against the U.S. dollar.

The last time the band was widened, in April 2012, it was doubled from half a percent to one percent. This latest move will be seen within China as being more ambitious than it will be seen outside of it. On what there will be agreement is that it is another step towards the yuan becoming fully convertible — though it has a long way to go even to challenge the dollar let alone eclipse it.

It is also a sign that policymakers have confidence that the economy, though experiencing slowing growth, remains strong enough to enable the continuing drive towards financial reform. Greater exchange rate fluctuations may also deter hot money inflows, allowing the central bank to tighten monetary policy to throttle rapid credit expansion. They will also increase the demand for the introduction of financial products that can be used for currency hedging.

China’s Central Bank Takes A Swipe At Speculators

CHINA’S CENTRAL BANK has been acting out of character this week — or at least out of recent character. It has surprised and alarmed investors by unexpectedly pushing down the value of the yuan against the dollar and easing its tight grip on money markets. Its goals, this Bystander assumes, have been to take another shot at the speculators who still see the appreciation of the currency as a one-way bet, and to ease the high interest rates that continue to attract hot money.

Hard-pressed equities and real estate investors won’t be sorry to see rates easing either. Nor will the shadow banking system nor highly indebted state-owned enterprises. All of which might make for a more welcoming backdrop to the annual session of the National People’s Congress due to start shortly.

However, juicing the slowing pace of growth and forestalling any unseemly defaults in the financial system while lawmakers are gathered comes at the price of suspending the central bank’s effort to let down the country’s credit bubble and deleverage systemic financial risk. That, though, cannot continue for too long if the bigger goal — rebalancing the economy towards greater growth from consumption and away from exports and infrastructure investment — is to be pursued.