In brief

• The Chinese yuan (CNY) may soften in the near term but we think structural factors portends strength in the CNY in the medium term
• Robust, still-growing Chinese current account balance, and increasing foreign direct investment (FDI) inflows into China offer stability to the currency, while basket tracking of other strengthening currencies may allow for further strength in the CNY
• Clarity in FX fixing policy will offer a better sense of direction for the CNY

Since Jan 2020, despite the pandemic and other economic shocks, the CNY has performed well and has appreciated by close to 9% against the USD and 14% against the trade-weighted currency basket (data as of March 18). Even as we enter 2022, before the Chinese market correction between March 10-15, the CNY continued to be one of the better Asian FX performers and has exhibited the properties of a safe haven asset, appreciating against the USD as well as other major currencies. This appreciation took place despite a slowing Chinese economy, and at a time when the People’s Bank of China (PBoC) is easing monetary policy, in contrast to most other major central banks that are embarking on policy tightening cycles. 

We attribute this to two key factors:  

(1) China’s strong current account: China has acted as the world’s ‘producer of last resort’, especially during the pandemic, with exports up 29.7% year-over-year in 2021. In particular, the trade surplus hit a record USD 677bn in 2021 versus the pre-COVID-19 level of USD 421bn in 2019. China’s current account surplus as a percentage of GDP has also risen from 0.7% in 2019 to 1.8% in 2021.

(2) Ongoing strong foreign investment inflows: Foreign holdings of Chinese equity stocks and bonds grew from the pre-COVID-19 level of USD 0.63tn at the end of 2019 to USD 1.26tn at the end of 2021. FDI also increased from the pre-COVID-19 level of USD 138bn in 2019 to USD 174bn in 2021, as Chinese markets continued to open up and China’s industrial chains displayed resiliency and stability during the pandemic. On the other hand, partly due to the tight border control as well as the ongoing pandemic, China’s outward direct investment has seen almost no growth in the past two years.

As these positive structural factors will likely remain intact in the coming months, we believe the CNY's strength will still have legs in the medium term. In particular, we continue to expect the USD to stay under pressure in the medium term given its high valuation and structural factors of the U.S. economy, such as persistent current account and fiscal deficit. U.S.’s trade deficit actually worsened during the pandemic and this should put more downward pressure on the USD going forward. Also, as the economic reopening plays out in other economies and their growth momentum picks up, narrowing growth differentials may also weaken the greenback. This would set up a constructive environment for the CNY to appreciate. 

Source: China Foreign Exchange Trade Center, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management.
*CFETS CNY Index is the China Foreign Exchange Trade System basket of 24 currencies traded against the Chinese renminbi, where the base value was set at 100 as of 31/12/14. Past performance is not a reliable indicator of current and future results.
Guide to the Markets – Asia. Data reflect most recently available as of 24/03/21.

However, in the near term, the room for further appreciation has admittedly become more limited as the U.S. Federal Reserve (Fed) started hiking rates. The upside biases to the USD/CNY fixings last week by the PBoC also seemed to suggest growing policy discomfort with further CNY strength in a bid to support growth.

That said, we notice the daily fixings have become more in line with market expectations ever since the  State Council meeting last week, suggesting the objective to limit appreciation has probably been fulfilled. Moreover, recall 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 also force the CNY to be stronger against the USD to maintain the overall basket’s stability. Therefore, even if the PBoC implements additional measures to slow down currency appreciation, we believe the CNY would still be allowed to rise.

Meanwhile, given China’s soft inflation prints, China’s real rates should remain positive even when the monetary policy remains accommodative, and this should help support CNY and prevent severe capital outflow. This is in contrast to the U.S.: even as the Fed further hikes rates, the U.S. real interest rates will likely remain negative due to still elevated inflation.

Investors are always concerned about the competitiveness of Chinese exports being eroded by a stronger CNY. While this may be true, in the current environment with rising oil prices and increasing input cost pressures, higher export prices may actually help mitigate at least part of the potential trade balance losses. We also believe the Chinese authorities prefer at least a steady USD at the current juncture in order to attract foreign investment and prevent capital outflow, especially at a time when investor confidence is shaky.

Investment implications

Against the current backdrop, we expect the CNY to soften against the USD but remain largely stable in the near term. However, structural factors as highlighted above should remain intact in the medium term, thereby providing support to continued CNY outperformance. This could enhance Chinese onshore assets’ appeal to international investors.

As discussed in our previous publication “Things to watch out for that would reinforce confidence on Chinese equities”, more concrete policies and results are needed to address investors’ skepticism and improve confidence. Indeed, shortly after the State Council meeting last week, China’s State Administration of Foreign Exchange (SAFE) announced monitoring and management of its foreign exchange market will be stepped up, primarily by guiding market players on FX hedging and coordinating with other agencies to calm market outlook. Hence, we will continue to monitor if SAFE will announce a more detailed roadmap to revive market confidence. Further,  we should also monitor (1) the upcoming PBoC meeting at the end of the month to see if there is any comment on its FX policy; and (2) pay attention to the daily PBoC USD/CNY fixing and compare it against the market expectation in the next few weeks to gauge whether the authorities may start to use more of their FX toolkit to curb CNY strength. 

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