The Chinese yuan (CNY) has strengthened by 6.3% since late May. This was likely driven by unexpectedly strong performance in exports, solid recovery from COVID-19 and also growing interests by international investors in Chinese onshore assets. That said, the change in foreign reserve data indicates that China has been experiencing capital outflows in recent months. While there is no clear explanation for this outflow, the latest policy announcement by the People’s Bank of China (PBoC) shows that it would like to moderate the pace of currency appreciation. However, recent experience suggests the central bank could still tolerate a stronger currency.
The PBoC announced on October 10 that it will reduce the foreign exchange (FX) reserve of banks’ forward FX sales business from 20% to 0%, effective October 12. This measure has been deployed several times in recent years to fine tune the direction of the currency. It was last raised from 0% to 20% in August 2018 when the CNY was under depreciation pressure during the h eight of U.S.-China trade tension. The last reserve cut took place in September 2017 during the previous bout of CNY appreciation when the global economy was enjoying a synchronized rebound. During this episode, the CNY did weaken initially but the broad U.S. dollar (USD) weakness continued to drive the CNY stronger in late 2017 and early 2018.
We continue to expect the USD to stay under pressure in 2021 on the back of low USD interest rates versus other developed economies, and structural factors in the U.S., such as persistent current account and fiscal deficit. A gradual global recovery should also weaken the greenback. This would set up a constructive environment for the CNY to appreciate. Don’t forget that the PBoC manages the CNY relative to a basket of currencies, such as the Australian dollar, British pound, euro and Japanese yen. The strength of these currencies would force the CNY to be stronger against the USD to maintain the overall basket’s stability. Even as the PBoC is implementing measures to slow down currency appreciation, we believe the CNY would be allowed to rise.
Investors could be worried about the competitiveness of Chinese exports being eroded by a stronger CNY. While this may be true, it would be partially offset by cheaper imports in components and raw materials, as well as stronger demand as the global economy recovers. Other than the trade of goods, a stronger exchange rate can help to attract more international capital into the Chinese equities and fixed income markets.
EXHIBIT 1: CHINA: EXCHANGE RATE AND CHANGE IN RISK RESERVE RATIO
Source: China Foreign Exchange Trade Center, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. *CFETS RMB index is the China Foreign Exchange Trade System basket of 24 currencies traded against the Chinese renminbi. Past performance is not a reliable indicator of current and future results.
Data reflect most recently available as of 12/10/20.
Investment implications
The CNY could face consolidation in the near term, given the latest policy measure from the PBoC. Moreover, investors could also wait for the outcome of the U.S. elections to determine whether the CNY would start to weaken again if the threat of tariffs returns. Nonetheless, we expect the currency to gradually strengthen in 2021 on the back of economic outperformance.
This could enhance Chinese onshore assets’ appeal to international investors. The COVID-19 pandemic has accelerated consumer adoption of technology in China. The strained relationship between the U.S. and China has prompted Beijing to place more emphasis on domestic research and development of technology to push for greater self-sufficiency. These ongoing development growth themes are good reasons for investors to stay constructive on Chinese onshore equities. The solid economic recovery also provides a cyclical boost to corporate earnings over the next 6-12 months.
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