China’s Strengthening Currency is increasingly outside Beijing’s Control

Allowing more foreigners to buy the country’s bonds means strong inflows of capital to China, but that also means abdicating some control of the country’s financial conditions or currency

By geust author Mike Bird from Wall Street Journal

Caption and Graphic courtesy by Wall Street Journal

The Chinese yuan has strengthened this year, and the country’s central bank seems to be trying to slow the rise. But having ceded a portion of the currency’s control to international markets, there’s less they can do this time around.

The People’s Bank of China has suspended the so-called countercyclical factor of its daily fix of the yuan, a tweak which helps it prop up the currency when desired. It has also lowered reserve requirements on currency forwards. It’s not the first time the central bank has done either, but the moves are a demonstration of efforts to keep the currency’s rise in check.

Strong demand overseas for Chinese goods has raised the country’s trade surplus sharply in 2020. The currency has strengthened by almost 7 % against the Dollar since its May low, and now trades at around 6.72 to the greenback. The country’s admission to major bond- and equity-market indexes has also boosted portfolio flows from international investors.

Foreign investors have bought around 370 billion Yuan, equivalent to USD 55 billion, in Chinese government bonds on a net basis this year according to China Central Depository & Clearing Co. data, increasing their share of ownership marginally as government issuance surged. That’s still a little slower than the burst of buying at the same point in 2018, at the peak of foreign purchases.

For a developing economy with fewer capital controls, the response to a currency strengthening beyond the levels the government wanted could be relatively simple. The central bank could cut interest rates, or at least allow the prices of the bonds to rally, bringing market yields down.

That is an awkward option for Chinese authorities, with the central government nervous of unleashing the sort of corporate credit boom it did in the aftermath of the financial crisis in 2008-10, or fuelling the continuing surge in household debt centred on the real-estate market.

Major capital inflows are the sort of problem many developing economies would not mind having, and indexation-related flows will likely be less flighty than the hot-money flows Beijing has feared since the time of the Asian financial crisis. But allowing them cedes some control of a country’s financial conditions to international markets.

The fact that the economy is now classed as an emerging market for the purposes of many bond and equity investors internationally will put pressures—both upward and downward—that other emerging markets are very familiar with.

Another factor of close interest is what happens in the U.S. election next week. It is impossible to tell exactly how much a less combative trade policy would be worth to the yuan, but market moves last year suggested a close link between the exchange rate and sentiment around China-U.S. commercial relations.

Whichever way the vote goes, China’s acceptance of greater inflows into its assets means abdicating some level of control of the yuan. As holdings rise further, Beijing may find it more difficult to keep the control of the exchange rate that it has previously exercised.