MNI EXCLUSIVE: Yuan Rally Losing Steam, Chinese Advisors Say

China should make its exchange rate mechanism more flexible in coming years to enable it to better absorb market shocks but the People's Bank of China should continue to manage the float, policy advisors told MNI, adding that the recent yuan rally appears to be losing steam despite volatility following the U.S. elections.

The onshore yuan is below 6.6 to the dollar, its strongest in more than two years. But supporting factors including the wide interest spread between Chinese 10-year government bonds and U.S. Treasuries and the weakness of the US dollar, are easing, said Chen Daofu, deputy director at the Financial Research Institute of the Development Research Center of the State Council.

The yield on 10-year CGBs should top at about the current 3.2% as government bond issuance declines, Chen said, adding that U.S. Treasury yields had little room to fall further. The current spread is at record levels at about 240 bps.

A more flexible, if still managed, exchange rate should be an objective for China over the next five-to-10 years, according to Chen. Like other advisors who spoke to MNI, Chen expects the yuan to trade in a wide range. Developing foreign exchange derivatives would help cushion risks for Chinese financial market participants, he said.

But short-term dollar weakness is possible following the U.S. elections, and the PBOC should act to provide guidance if one-way bets develop on yuan appreciation, while preserving its 2% limit on fluctuation from its daily fixing, Chen said.

In October, the PBOC said some banks had suspended use of the counter-cyclical factor in contributions to yuan fixing as the currency strengthened. It had earlier lifted a reserve requirement on FX forwards.

CAPITAL FLOWS

Dollar weakness should not continue as the U.S. economy strengthens and there is little chance for the yuan to rally below 6.5 this year, said Zhang Ming, a senior fellow at the Institute of World Economic and Politics under the Chinese Academy of Social Sciences.

Regulators should closely watch capital inflows and manage them if necessary, said Xu Hongcai, deputy director of the Economic Policy Commission of the China Association of Policy Science, warning that moves to open China's capital account should be gradual. Large inflows leading to any significant yuan appreciation would pressure exports, he said, adding that this year's good trade performance was partly due to temporary factors as Chinese goods displaced foreign factory output affected by the Covid-19 pandemic.

The U.S. elections triggered volatility in Chinese forex markets, and the offshore yuan saw a daily trading range of 1,500 pips last Wednesday, the widest since August 2015.

The yuan closed at 6.6041 at 16:30 on Monday, 313 pips weaker than the previous day, when it ended at its strongest against the dollar since June 2018. The PBOC set its yuan fixing at 6.5897 Tuesday, the strongest in over two years.