Financial Markets and the Yuan

SINGAPORE (Reuters) – Financial markets are betting that China will not use the yuan as a policy tool to offset expected U.S. tariffs in a second Donald Trump presidency. This perspective stems from the belief that a sharp depreciation of the yuan, similar to that seen in Trump’s first term, would be more detrimental than beneficial to China’s vulnerable economy.

From yuan forward pricing to interest rate derivatives and analysts’ forecasts, it appears that China is allowing a slow depreciation of the yuan to align with a stronger dollar in preparation for Trump 2.0.

Market pricing indicates a gradual depreciation is expected, with analysts predicting a 5-6% decrease from current levels by year-end. During Trump’s first term, the yuan weakened over 12% against the dollar amid U.S.-China tariff disputes between March 2018 and May 2020.

Trump’s recent threats include potential tariffs of up to 60% on Chinese imports, though reports suggest these may be implemented gradually. Analysts now believe the situation has changed; the yuan is already weak, the economy fragile, and portfolio investments are fleeing China. Additionally, Chinese exports to the U.S. have become a smaller part of overall trade, making significant devaluation difficult to justify.

Currently, the yuan hovers near 16-month lows and has declined for three consecutive years, down from near record highs of 6.3 per dollar in 2018. Discussions in official circles have considered allowing the yuan to fall to 7.5 per dollar, roughly a 2% decrease from current levels. Much of this decline is predicted to result from widening interest rate differentials between the U.S. and China, now around 300 basis points.

The dollar remains at elevated levels around 7.3 yuan, and analysts suggest significant breaks above this threshold are unrealistic. Nearly half of China’s $1 trillion trade surplus is with countries outside the U.S., particularly neighbors like Vietnam, who have developed as assembly hubs for Chinese goods.

In previous sharp falls of the yuan in 2015 and 2019, China was compelled to clarify its policies and assert it was not engaging in currency devaluation strategies. A weaker exchange rate benefits exporters by making prices more competitive internationally.

China bears responsibility to maintain relative currency stability due to its considerable trade surplus with the world. The People’s Bank of China (PBOC) has recently stated that it possesses sufficient foreign reserves and experience to maintain a fundamentally stable yuan at a reasonable equilibrium.

Importance of Stability

Domestic economic issues also necessitate a stable currency to prevent capital flight as residents and businesses seek to convert assets into foreign currencies. Diminishing domestic bond yields and unstable stock and property markets have prompted a rush to hoard dollars. A volatile renminbi would likely push individuals towards USD or gold, which the PBOC aims to avoid.

The PBOC has aimed to limit the yuan’s weakness, attempting to keep it strong in trade-weighted terms. The CFETS yuan index, measuring against a basket of 25 currencies, remains near a two-year high, indicating that the yuan is less competitive than trading partners’ currencies.

Authorities have intervened by supporting falling domestic bond yields and advising companies to borrow internationally to attract foreign capital. The central bank frequently fixes the yuan’s trading band at stronger levels than anticipated by the market. Despite pledges to ease monetary policy and stimulate growth by 2025, markets are pricing out potential rate cuts as they believe PBOC will prioritize yuan stability.

Alpine Macro’s China strategist Yan Wang projects the 7.7 level for dollar/yuan as the PBOC’s upper limit, suggesting an approximate 5% further decline.

“Yuan pressures may be hard to avoid in the near term but can be managed to ensure trade-weighted stability,” noted Mizuho’s Vishnu Varathan.

($1 = 7.3317 Chinese yuan renminbi)