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BEIJING (MNI)

The yuan could briefly strengthen to 6.4-6.5 to the dollar, but should mostly trade between 6.5 to 6.6 over the next six months as the world's second-largest economy faces headwinds, the interest spread with U.S. bonds narrows and the greenback recovers, a senior fellow at a Chinese government-sponsored think tank told MNI.

To ease upward pressure on the yuan, the People's Bank of China could loosen controls on capital out-flows, such as by granting more quotas for qualified domestic investors to buy overseas assets, Zhang Ming, deputy director of the Institute of Finance and Banking under the Chinese Academy of Social Sciences, said in an interview.

But, while the yuan's recent appreciation has been too steep, its fundamentals are weakening, he said. China's recovery still faces headwinds and the U.S.-China interest spread could narrow as the U.S. recovery gains pace, driving a recovery in the dollar index next year.

"It is too optimistic to say that the yuan has entered into an appreciating cycle, which usually lasts for three to five years, as strong support from fundamentals has not formed yet," said Zhang.

USDCNY has dropped by about 8% or 6,000 pips since June, touching a 2-1/2-year low at 6.5630 in early November. It traded at about 6.57 on Tuesday. Lower USDCNY signifies yuan appreciation.

RALLY

Authorities have warned that the yuan's strength is affecting Chinese exporters, Zhang noted.

The BIS effective exchange rate index, which measures the yuan against a basket of currencies, rose 0.65% to 125.67 in October, the highest in six months after four consecutive months of appreciation. The yuan's EER gained 2.81% in the first ten months of the year, compared with a 0.95% rise for the whole of 2019 and a 0.86% drop in 2018.

But any move by the PBOC to allow more capital outflows should be measured, to avoid a rush of funds out of China, Zhang cautioned, pointing to evidence of investors trying to shift money abroad reflected in the errors and omissions item in the State Administration of Foreign Exchange's balance sheet.

The yuan's rally has been driven by China's quick recovery from a pandemic which hit other countries later, by widening interest rate spreads between China and the U.S and by dollar weakness against the euro, Zhang explained.

All three factors are now losing steam, Zhang said. While low base comparisons should push Chinese growth over 8%, underlying performance will be sluggish, he said. Exports are unlikely to maintain the double-digit growth seen in Q3, as other nations' factories resume production following pandemic disruption and demand for medical supplies eases with the arrival of Covid vaccines. Sales of products used for telecommuting, such as laptops, should also slow, he said.

Infrastructure investment should be the major driver for the economy in 2021, as consumption is sapped by the pandemic hit to middle- and low-income groups, manufacturing investment remains weak and strict regulations limit property sector finance, according to Zhang.

SPREAD

The PBOC should maintain interest rates at low levels in order to facilitate government borrowing to fund the infrastructure spending and rollovers of outstanding debt, Zhang said, adding that the yield on 10-year CGBs may be approaching its peak at current levels just above 3.3%.

Recent corporate defaults, including by some state-owned companies, have also rattled investors, adding to the argument for keeping rates low, he said.

The China-U.S. interest spread may narrow to about 150 basis points from the current record high at 250bps. The yield on 10-year U.S. Treasuries should rebound to about 1.5% as the incoming Biden administration applies fiscal stimulus in the first quarter of 2021, Zhang said.

The dollar index is unlikely to weaken much below 90, as the eurozone is being harder hit by the Covid second wave and its recovery will lag that of the U.S., undermining the euro, he said.

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