TOKYO – The five most dangerous words in economics are “this time things are different.”
Except, when they really are. A case in point is how the unlikely strength of the Chinese yuan is reordering global currency market dynamics. And, perhaps, creating a new power-sharing arrangement between the two biggest economies.
“A striking feature of the turmoil of the past year is that it is the first major global economic dislocation in which China has allowed its currency to strengthen, rather than keeping its value pinned in a very tight range,” says economist Wei He at Gavekal Research.
Part of the yuan’s 10.5% gain over the last 12 months is a mechanical response to a weakening dollar. The yuan could now be near the top of the trade-weighted range that Beijing is comfortable with. As long as the dollar continues to drift lower, strategists say, the yuan may keep rising against it.
But taking a longer-term view, He says, “we have probably passed a key inflection point in the renminbi’s development into an international currency. Over any timeframe between the last 12 months and the last 10 years, the renminbi has been the best-performing major currency on a total return basis.”
Another inflection point could soon come with the full launch of the People’s Bank of China (PBOC)-backed digital yuan, which would make the currency more viable for global payments.
He noted that “the combination of a more credible and easier to use renminbi and the solid returns now available for fixed-income investors in China means that global capital will increasingly flow towards Asia.”
Yen, euro, yuan?
Yet the passing of the currency guard may be the wrong lens to view what’s afoot. The yuan’s rise in finance and trade is often viewed in zero-sum terms – that, before long, national leaders, corporate executives and investors will have to choose between the dollar and the yuan.
And given America’s near US$30 trillion debt load and gridlock-plagued government, the yuan seems destined to eclipse the dollar sooner rather than later.
This is very much Ray Dalio’s view. The founder of the globe’s biggest hedge fund, Bridgewater Associates, argues the yuan will supplant the dollar as the global reserve currency sooner than the conventional wisdom believes. Dalio, too, is betting that the digital yuan will turbocharge demand for China’s currency.
But then traders have thought the dollar’s days were numbered before.
Thirty years ago, it was the yen that was thought to be on the ascendency. Then it was the euro. Today, the dollar remains well ahead of the euro’s 36% role in cross-border payments and the yen’s less-than-4% share. The yuan’s 2.4% share marks a healthy increase from 1.65% in January 2020 – but is still just 2.4%.
However, China’s scale gives it much better odds than the other claimants. Its ability to catch up with the dollar’s 40% lock on global payments is certainly doable.
It will, however, require a level of political will that President Xi Jinping has yet to display to open China’s capital account, increase transparency, allow full convertibility and tolerate the free flow of information and opinions.
Given the underlying cracks in China’s financial system – as evidenced by the default fears surrounding state-owned China Huarong Asset Management Co – China’s process of grabbing the crown could take longer than Xi may have hoped.
In the interim, it may be more realistic to expect the “emergence of a bipolar world order led by rival hegemons,” says economist Paola Subacchi at the Queen Mary University of London.
Not either, but both
This, Subacchi argues, is the logical reaction to former US president Donald Trump’s strategy of “encouraging the decoupling of the world’s two largest economies.”
As analyst Richard McGregor at Lowy Institute likes to say: “There’s no floor under the US-China relationship. We keep finding new lows.”
As such, a bipolar economic world is taking shape. Under Trump, the name of the game was erecting a great wall of opposition to Xi’s ambitions in Asia and beyond. Under newish President Joe Biden, it’s more about putting a better competitive team on the field.
A bipolar world could indeed work out just fine for the East and West. As the yuan increases in status, transaction volume and liquidity, it will provide a hedge against the dollar, and vice versa.
It will increase stability in global capital markets. This dual-center world will keep pressure on reformers in both Beijing and Washington to keep raising their respective economic games.
The inflection point that Gavekal’s He detects comes as the yuan rises to the highest level since early 2016. More importantly, officials in Beijing are tolerating the gains, suggesting a growing air of confidence. Their rising comfort with exchange rate strength may portend additional gains.
Exports versus commodities
Whatever China gives up in demand for exports, says economist Eddie Cheung at Credit Agricole CIB, it gains in “dealing with higher global commodity prices.”
In April, China’s producer prices rose the most since 2017 amid soaring costs for imported raw materials like iron ore and copper. A stronger yuan typically tames inflationary pressures by making imports cheaper.
China is not letting the yuan totally off the leash. The last few days saw authorities taking clear action to cap the appreciation. The PBOC demanded that lenders keep as reserves at least 7% of their foreign-exchange holdings. That move, effective June 15, marks a 2 percentage-point increase, giving it teeth.
This first such hike since 2007, though, isn’t aimed at weakening the yuan, but rather taming the amplitude of its ascent. It’s a sage step, aimed at cutting the supply of dollars and other monetary units onshore.
Shen Songcheng, the PBOC’s former statistics chief, warns the yuan is “overbought” and that policymakers need to get a handle on short-term inflows.
On the other hand, Liang Tao, vice-chair of China Banking and Insurance Regulatory Commission, or CBIRC, wonders if recent monetary tightening moves among emerging-market policymakers could lead to the popping of financial bubbles, and all the economic fallout that might cause.
On Sunday, the PBOC put out an unusual statement: Beijing’s exchange-rate policy has not changed.
One possible motivation was recent excitement caused by comments from Lu Jinzhong, head of research at the PBOC’s Shanghai branch. Lu hinted that Beijing should engineer a stronger yuan to combat higher commodity prices fanning domestic inflation.
And Zhou Chengjun, director of the PBOC’s Finance Research Institute, created a sensation with recent comments. He said that the yuan, if it becomes a truly international currency, would require Xi to let exchange rates go wherever punters deem appropriate.
The PBOC’s leadership sought to quash such rabid market speculation.
Deputy Governor Liu Guoqiang said, rather bluntly, that markets shouldn’t get in a whirl about the musings of lower-level bureaucrats.
“The PBOC’s caution about an appreciating exchange rate makes sense,” says Gavekal’s He.
On the one hand, a rising exchange rate does not seem to be slamming Chinese competitiveness – at least for now. Exports are picking up, rising to a two-year annualized growth rate of 17% in April.
“But,” He warns, “exports are clearly being supported by temporary boosts to demand and shortages of supply, which will probably offer less support by the second half of 2021. The PBOC doesn’t want exporters to be stuck with an uncompetitive exchange rate when that happens, or risk potential financial instability by depreciating the currency to adjust.”
The Fed’s wild card
Here, the US Federal Reserve is a big wild card.
Perceptions about when the Fed might taper its post-Covid-19 quantitative easing are on a roller coaster. Since news of the biggest jump in US consumer prices in 13 years, traders have come to the view that pockets of softness in the economy will preclude big monetary shifts.
The market, notes Anders Persson, chief fixed-income investment officer at Nuveen, “is sort of priced for reality.” What that reality really is may come into greater focus on Friday, when the US releases its May unemployment report.
Others worry dollar-yuan dynamics hint at a very different inflection point: a dollar crash. Count Stephen Roach, former chairman of Morgan Stanley Asia, who argued in January that “the dollar’s crash is only just beginning,” staunchly among them. More recently, he argued “why in the world would you own dollar debt?”
Peter Schiff at Euro Pacific Capital can’t help but wonder if the yuan’s steady advance is pulling the rug out from under foreign-exchange market rhythms. Schiff, it’s worth noting, was one of the very few economists who called the 2008 subprime crisis.
Now, he is watching how high the yuan – currently at 6.36 to the dollar – might go, causing tectonic shifts in global economics.
“The US dollar hasn’t been below 6 yuan since the major yuan devaluation in 1993,” Schiff notes. “Once the dollar breaks below 6 it could crash against the yuan, sending China’s GDP above US GDP.”
Yet the good news is that the globe’s top two powers are recovering in unison, at long last. China first, of course. Mainland growth is expected to be well north of 6% in 2021, perhaps even approaching 8%.
And rising US demand is a boon for China, and vice versa. Though Biden has been slow to scrap Trump-era tariffs, Beijing can take comfort that there won’t be new taxes thrown at its all-important export engine.
It would help, of course, if the leaders of the G2 Group were talking more. For now, currency markets appear to be doing the talking for them.