Yuan’s Slump Forces China Into Balancing Act to Help Recovery

The Chinese yuan’s slump to its weakest against the dollar in almost two years adds to what is already a precarious balancing act for Beijing, which is seeking ways to prop up its struggling economy without stoking financial instability.

There’s opportunity in the falling exchange rate, which cushions exporters and provides an additional source of support as the People’s Bank of China lowers interest rates and as provincial governments borrow to fund infrastructure. Authorities have been trying to put a floor under a slowdown spurred by China’s deepening real estate crisis, as well as an ongoing hit to consumer and business sentiment fueled by a stop-start Covid containment strategy.

“Yuan depreciation seems one last policy option left,” said Gene Ma, chief China economist at the Institute of International Finance in Washington. “Housing has failed to respond to policy easing and monetary policy has fallen into a ‘liquidity trap’ as loan demand is so weak.”

A weaker currency accelerates capital outflows

A weaker currency, though, also accelerates capital outflows and market volatility. The more the yuan is allowed to drop, the deeper the divergence will be between the financial markets in China and the US, where the dollar is approaching a record high. The central banks of the world’s two largest economies have already been heading in opposite directions this year.

The volatility is also a potential threat to emerging economies, which in recent decades have leaned on the yuan as an anchor of stability on the back of surging trade flows. China’s steep slowdown is already weighing on some of its most vulnerable trading partners -- such as South Korea, Singapore, Malaysia and Taiwan -- given that many of them sell the commodities and input goods needed to feed manufacturing supply lines in the world’s second-largest economy. 

“With China now the biggest trading partner of many emerging market economies, they -- and their currencies -- have become increasingly tied to China’s cycle,” said Dave Loevinger, Los Angeles-based managing director at TCW Group Inc. “Moves in emerging market currencies and the yuan have become more correlated as China’s share of trade with emerging economies has risen, particularly in Asia,” he said.

Moving capital out of the country

For China, pronounced yuan weakness would accelerate the flows of investor capital leaving the economy, as well as pressure households and companies to move their savings out of the country. A sudden drop in value in 2015 ultimately forced the government to burn through $1 trillion worth of reserves, and to enforce strict capital controls that made it even harder to move money in or out.

For now, the yuan’s decline appears to have remained within the comfort zone of authorities, even though both the onshore and offshore yuan are at their weakest levels since September 2020. The offshore yuan has fallen about 2.4% this quarter, the second-worst performer in Asia after the South Korean won. 

In a front page commentary Wednesday, the Securities Times said the widening gap between China and US interest rates has limited impact on the yuan, adding that its strength is supported by the country’s trade surplus.

China’s trade-weighted yuan is still holding up well against 24 of its major trading partners, partly supported by its trade surplus. The Bloomberg CFETS RMB Index tracker is hovering above 102, up from this year’s low of 100 in May.

Deliberate devaluation

Few analysts expect an even steeper decline, and they say a deliberate devaluation of the kind seen in 2015 that roiled global markets is unlikely. Concerns over imported inflation are expected to limit the yuan’s fall, while robust exports have continued to offer support. The strong dollar remains the bigger concern for many emerging economies.  

“Given the fact that the PBOC seems to have adopted a less interventionist approach, a moderate depreciation, less than 5%, would not fuel global market volatility and cause a major disruption in the EMs,” said Bo Zhuang, senior analyst at Loomis Sayles Investments Asia in Singapore.

Still, it’s tricky to gauge how much weakness should be allowed. Investor outflows from China have been persistent as the Fed raises interest rates while the PBOC cuts them. 

Analysts from Standard Chartered Plc and Mizuho Bank Ltd. are forecasting the yuan to weaken as the PBOC’s dovish policies increasingly contrast with the Fed’s hawkish ones.

Sentiment on China remains fragile as economists have warned of even weaker growth and called for additional stimulus, such as further cuts in policy rates and bank reserve ratios and more fiscal spending. Both Goldman Sachs Group Inc and Nomura Holdings Inc have cut their gross domestic product forecasts this year to 3% growth or less.

It’s more likely than not the yuan will fall further ahead of China’s all-important 20th Communist Party Congress expected later this year, when President Xi Jinping is expected to cement a third term in office, according to Fiona Lim, a senior foreign exchange strategist at Malayan Banking Bhd in Singapore. 

“Yuan depreciation is gathering momentum,” Lim said.