Morning Commentary: The Chinese Yuan: A Near-Term Wobble but Continued Long-Term Strength

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The Chinese Yuan: A Near-Term Wobble but Continued Long-Term Strength  Share this story: Andrew Kositkun Senior FX Advisor

Over the second half of 2020, Chinese yuan appreciation has pretty much been a straight line. It’s been a slightly different story to start 2021 as trend strength has morphed into consolidation.  Nevertheless, the expectation remains for the yuan to continue to strengthen over the first half of 2021, albeit at a slower pace than what was seen in 2020. This view for further appreciation is grounded in the expectation for continued GDP outperformance, strong external sector performance, effective COVID-19 control, a sizable carry advantage and strong portfolio inflows.  Additionally, the People’s Bank of China’s (PBoC) hands-off approach is also supportive of further gains. In essence, the PBoC desires greater yuan internationalization and two-way flexibility in the exchange rate. As such, the central bank is unlikely to lean heavily against further appreciation, as valuations are not stretched and exports are not feeling too much pain as growth forecasts continue to be revised higher.  Furthermore, U.S.–China tensions should be less volatile going forward. This market expectation can be seen through the sharp drop in yuan risk premium leading up to the U.S. elections as the probability of a Democratic victory increased. This eye toward the next administration is why market sentiment was not materially impacted by executive orders from the outgoing Trump administration that ramped up pressure on China and Chinese companies.  In the near term, the Biden administration is likely to focus on a comprehensive review of U.S. policy toward China. This should include reviewing the Phase 1 trade deal (Chinese purchases are substantially below minimum purchase targets) and existing tariffs and sanctions as well as developing a dialogue with the Chinese government and bolstering U.S. partnerships in the Asia-Pacific region. Over the medium term, the Biden administration is expected to focus on a policy of competition and deterrence toward China that focuses on protecting technology critical to U.S. innovation and national security.  Returning to the yuan, the currency’s relative attractiveness will likely become less clear during the second half of 2021 as China’s relative outperformance starts to slow and rising U.S. yields provide a more constructive U.S. dollar outlook. But until then, expect continued yuan support. HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: U.S. equities opened the week mixed as investors weighed the latest on fiscal stimulus, lockdowns and the bumpy vaccine rollout as well as waiting on a slew of Big Tech earnings and the Fed meeting this week.  On the U.S. stimulus front, Director of the National Economic Council Brian Deese held a virtual meeting with a 16-member bipartisan group of senators over the weekend. According to reports, some senators from both parties prefer a smaller bill that focuses on funding and distributing vaccines versus the larger more encompassing bill that the White House proposes. In the end, the White House proposal was always just a starting point, with the hard work of achieving a compromise underway.  The House will deliver Donald Trump’s impeachment article today, with senators sworn in as jurors tomorrow. However, arguments have been pushed back until the week of Feb. 8. The virtual World Economic Forum started today, with Chinese President Xi Jinping warning against confrontation and a new Cold War. This is his first address since Biden became president and signals China’s intention to continue forging its own path. While President Biden is not due to take part in the meeting, Emmanuel Macron, Angela Merkel and Yoshihide Suga will be among the world leaders speaking.  European Central Bank (ECB) Governing Council member Olli Rehn stated that yield-curve control was “not sensible” for the eurozone, as the at least 19 different yield curves in the area reflect the vast economic and financial differences between countries. The ECB, as part of its ongoing strategy review, is currently looking at how to define and maintain favorable financing conditions.  On the virus front, Norway has tightened restrictions due to an “outbreak of the English virus mutation.” In France, the government is considering a third lockdown, while the U.K. is in discussions to close its borders.  Japanese Prime Minister Yoshihide Suga’s government continues to lose support. The latest Asahi poll shows cabinet approval dropping to 33% from 39% last month, with the disapproval rating rising to 45% from 35% last month. Suga’s drop in the polls increases the chances of a change in leadership as well as additional fiscal stimulus.  According to data out of the U.N. Conference on Trade and Development, China has overtaken the U.S. as the world’s top destination for new foreign direct investment in 2020. While China attracted more new foreign direct investment inflows, the U.S. remains significantly ahead on a total stock of foreign investment basis.

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