MNI: Yuan Supported By Rebound But Firm USD Risks Move Above 7

The Chinese yuan is expected to be supported by the recovery in economic activity, but the possible renewed strength in the U.S. dollar risks pushing it above the closely watched 7 level and keeping the People’s Bank of China alert to any sharp moves in the currency, economists and traders told MNI.

The ongoing rebound in China’s economy was confirmed by stronger-than-expected PMI data on Wednesday, particularly robust new export orders, which triggered an inflow of around CNY7 billion of capital inflow into the A-share market and powered a rally that steered the dollar-yuan pair to below 6.9. The data dispelled the gloom about the recovery, which together with a jump in the U.S. Dollar Index, had driven the offshore yuan, or CNH, to a low of 6.9890 last month and within sight of the 7 level.

China’s economic fundamentals do not support a break above 7, while domestic companies were keen seller of dollars as CNH touched 6.98 against dollar last week, a commercial bank FX trader told MNI. The trader said capital inflows, which have supported the currency this year, should be sustained given China’s National People’s Congress would deliver more stimulus and detail a reshuffle of top officials tasked with supporting growth and driving reforms. (See MNI: China’s NPC To Target Growth Above 5% With Help From PBOC)

He predicted the yuan would fluctuate around 6.9 against dollar in the short term unless the U.S. Dollar Index continued to rise to over 106, with 6.7-7.2 expected to be the trading band for the year. However, caution around China-US tensions and the possible “silence” on policy should be watched, noting that last week’s capital outflows of CNY4.1 billion for the A-share market, the first weekly net capital outflow this year, showed some offshore investors remained cautious.

7 NO LONGER TABOO

The increased flexibility of the yuan exchange rate shows the 7 level is less taboo for the PBOC. The central bank noted in its latest monetary policy report there have been three breaks of 7 since 2019, and each time the currency rebounded. (See MNI BRIEF: Yuan To Remain Stable and Flexible - PBOC's Yi)

The 7 level is not a level that the PBOC must stick to as long as any sharp depreciation does not undermine sentiment towards two-way volatility, said Lian Ping, chief economist at Zhixin Investment. He said the PBOC had indicated its policy stance via issuing as much as CNY25 billion of central bank bills in Hong Kong last week to drain yuan liquidity. Lian expects the yuan to trade between 6.3 and 7.1 this year.

The trade balance should remain in surplus even if exports weaken, while capital inflows into China’s equity and bond markets will be boosted by the recovery. This should help the currency rally over the year, though any depreciation should be in the first half and limited, Lian said.

In 2022, the yuan fixing dropped by a record of 8.5% against the dollar, while the CFETS currency basket was relatively stable with a fall of 3.7%. CFETS basket has remained stable in recent weeks despite moves in the yuan-dollar pair.

MORE VOLATILITY

The yuan may see a wider volatility band this year, which could see the pair trade as high as 7.4 should the dollar index breach 107 or move as high as 110, said Tan Yaling, head of the China Forex Investment Research. Wider interest spreads between China and the U.S. could boost the dollar.

Tan said it was too early to determine whether a weaker yuan could boost exports given softening external demand, though export demand could improve in the second half as U.S. companies work through inventories.

The yuan’s rally will not be without bumps an FX analyst at a state-owned bank told MNI, citing an increase in outbound tourism that will drag down the trade surplus, while overseas investment will increase as Chinese companies seek to expand overseas. Large dollar holdings held by Chinese exporters and banks, estimated at about USD574 billion, adds another layer of uncertainty, he said.

Even though more volatility is expected, advisers think the PBOC will insist on increasing flexibility. Guan Tao, global chief economist at BOC International, said a flexible yuan would reduce the dependence on capital control measures when capital flows move sharply and increase confidence in advancing financial opening-up and yuan internationalisation.