You can’t always get what yuant

Reluctantly, the People’s Bank of China has set a soft fix for the onshore yuan, which allowed the offshore USDCNY rate to break above the psychological level of 7.00, transgressing this line in the sand for the first time in more than a decade (chart 1). The fact this level has been broken for the first time in a decade, after two serious attempts at the end of 2016 and 2018, demonstrates that the PBoC will struggle to have the yuan serve two different masters for the coming period. At the one hand, it does want to signal it stands ready to do “whatever it takes” against the US tariffs, despite running out of US export goods to slap extra tariffs upon. At the other hand, there are many reasons to believe China actually does not want to weaken its currency further. This is why we think the yuan will indeed continue to weaken, but in a managed and gradual way.

The simplistic argument is that China weakens its currency to gain an advantage in export markets, however, this ignores China’s recent financial history and strategic long term goals. First, an unstable currency may lead again to capital outflows just like in 2015-2016. Back then, the Chinese spend a large proportion of their foreign reserves to defend the yuan and prevent exactly this from happening. Second, China is in the middle of opening up its bond markets for foreign investors, with the goal of making more investable funds available for economic activity in China. Once again, an unstable currency is not supportive of this goal. Thirdly, as the current trade war with the US demonstrates, the Chinese economy is very dependent on the manufacturing sector which at the moment accounts for 40% of its Gross Domestic Product. The vulnerability of the manufacturing sector to swings in global demand is one of the reasons why China wants to move more to a consumer-based economy. This needs a strong yuan because a strong currency props up the purchasing power of Chinese citizens as many consumer goods in China are imported as well.

For now, the PBoC appears to be managing these often mutually exclusive goals by softening the onshore fix, while it gives verbal signals it is committed to a stable yuan. This, to some point, is backed up by the expected rate changes of the PBoC over the coming months. The PBoC is expected to leave rates unchanged over the coming 12 months, while to contrast, the Federal Reserve is expected to cut interest rates by almost a full percentage over the same time period. This different momentum in rate policies should provide some support for the yuan versus the dollar. This is why we consider that further weakening of the yuan will be managed and gradual as it seems the best compromise between signalling to the US it’s is willing to use all means to fight back, while also long term strategic goals are honoured.

The big risk in life, of course, is that you won’t always get what yuant.

Chart 1: The Chinese have many good reasons to keep the currency stable, which is why it has taken a decade for the USDCNY cross to reach this level, despite coming dangerously close two times before; at the end of 2016 and at the end of 2018.