China's yuan appreciation expected to continue in 2021

Beijing

CHINA'S currency has been rising for the past six months, with analysts expecting more appreciation of the yuan well into 2021.

Since May, the yuan has gained more than 10 per cent against the US dollar. Capital inflows are coming in on the back of the promise of higher economic growth in China, stronger interest rates and performing stock markets.

Chinese tourists are also staying home due to international borders still being largely closed, and will continue to do so for much of 2021, which will contract the services trade deficit.

Furthermore, the dollar is low and is not expected to bounce back as the US has to weather an economic downturn due to the virus and lockdown measures.

Official data published in December showed the value of China's foreign exchange reserves increased by about US$50 billion in November to US$3.18 trillion, the highest level since August 2016.

Between April and November 2020, foreign investors net purchased US$120 billion of inter-bank Chinese bonds.

There is still room for further growth. The International Monetary Fund, the Organization for Economic Cooperation and Development, and the World Bank all expect China's GDP to grow by over 7 per cent next year.

Meanwhile, the US and much of Europe are still grappling with fresh outbreaks of the Covid-19 virus and will sink into recession this year.

The Chinese government's 10-year bond now yields around 3.3 per cent, while the US Treasury 10-year note yields around 0.9 per cent and the benchmark German government 10-year bond yields a negative 0.6 per cent. This means there will be ample opportunity for investors in China next year.

Standard Chartered has predicted that the yuan would rise to 6.30 to the dollar by the end of the first quarter of 2021, while Citigroup sees a 10 per cent rise by the end of next year to 6 to the dollar.

"The macro recovery in China remains on track, and garners market confidence. Path of least resistance for Chinese real yields remains higher on the back of both supported nominal yields and easing inflationary pressures," Terence Wu, strategist at OCBC Bank in Singapore, said in a note.

While a strong currency supports China's goal of boosting the status of the yuan, it undermines much of its medium-term and long-term economic goals.

A stronger currency will make its exports less competitive. Global demand for Chinese-made medical devices and work-from-home products have so far boosted its exports, but the trend will wither as vaccines are rolled out worldwide.

As part of its next five-year plan China has urged for an upgrade of its manufacturing sector and aims to set technological norms.

Its economic growth, though less so than previously, still heavily depends on exports.

"The problem is the People's Bank of China probably does not have a political mandate to permit much sharper gains in the currency," said Logan Wright, China economist for the Rhodium Group.

He added: "Politically, few institutions in China are in favour of faster yuan appreciation, particularly officials within export-orientated provinces and those concerned more broadly about labour conditions. Employment is still suffering from the aftermath of the Covid-19 outbreak."

So far, the central bank's efforts to control inflows have not tempered enthusiasm for the yuan. To slow the advance, Beijing has made it cheaper for traders to bet against the Chinese currency and has relaxed capital curbs to allow more outflows.

In mid-December, it lowered a parameter on cross-border financing, a move seen by traders as trying to reduce China's overall size of foreign debt.

"Recent local forex actions suggest a desire for a slower pace of RMB appreciation. There are risks of more policies to allow for greater outflows and capital account convertibility in the months ahead, but these are unlikely to be trend-breakers," said Nomura's China economist Ting Lu.

The reality is that unless the central bank openly intervenes, it can only do so much to contain appreciation.

It can, for instance, encourage state banks to accumulate foreign assets and compensate them for any losses. But this solution is not sustainable over the long term.

"The central bank is in for a long fight against persistent inflows. Expect more appreciation (of the yuan), along with administrative measures to artificially encourage US dollar demand among banks and state-owned enterprises," said Mr Wright.