China’s FX Conundrum Dampens Stimulus Optimism: McGeever, Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) – The recent stimulus measures introduced by China this week appear to be largely influenced by the U.S. Federal Reserve’s significant interest rate cut just days prior.

However, Chinese policymakers may find themselves in a challenging position due to the Fed’s aggressive easing strategy and its effects on the yuan-dollar exchange rate.

Surprisingly, the yuan’s considerable appreciation against the dollar over the past two months was unexpected. While a grim domestic economic outlook negatively impacted Chinese stocks and bond yields, the yuan surged to its highest level in 16 months.

This week, the yuan received an additional boost as Beijing launched a series of trillions of yuan worth of liquidity, monetary, and fiscal stimulus measures. The currency has now surpassed the 7.00 per dollar mark for the first time since January 2023.

This recent surge aligns with investors’ optimism that Beijing is finally implementing meaningful initiatives to stimulate growth. It’s noteworthy that the yuan’s rise is accompanied by a rebound in stock prices and higher bond yields.

In the long term, a strong yuan can be beneficial for China as it enhances foreign investor confidence and attracts capital inflows while increasing the country’s nominal dollar-denominated GDP — a key metric for Beijing if it hopes to compete with the U.S.

Currently, however, China’s annual nominal GDP growth rate lags behind that of Japan and the U.S., a development few anticipated just a few years ago.

The immediate situation, though, presents complexities. With growth plummeting and deflationary pressures increasing, a strong currency could be detrimental to China’s economy. While policymakers may welcome the renewed optimism, they likely do not want the strong currency that accompanies it.

Stephen Jen, co-founder of Eurizon SLJ and a longstanding observer of China, argues that Beijing is caught between difficult choices. As the Fed continues its easing cycle, the dollar’s value against the yuan is expected to decline.

Jen believes the yuan could fall by around 10% over the next year. He expresses concern that most investors are misaligned in their positions, which could result in a non-linear decline.

LIMITED OPTIONS

The People’s Bank of China cannot control the Fed’s decision to cut U.S. rates. If the central bank wishes to prevent an overvaluation of the yuan, it could either lower domestic lending rates or initiate a bond-buying, or quantitative easing, program.

However, there are constraints on the former and even less inclination for the latter. Consequently, one possible option to prevent the yuan from overheating is to purchase dollars.

This approach carries significant political risk. The ongoing trade tensions between China and the U.S. have exacerbated the political rift, leading China to reduce its holdings of U.S. Treasuries.

China’s official holdings of U.S. Treasuries have dropped by 30% from a post-pandemic peak of $1.1 trillion in early 2021. While its global dollar-denominated asset holdings have not diminished as much, the trend is clear. Increasing its purchases of U.S. currency and government debt could face significant domestic opposition within China.

Further complicating matters, the incoming U.S. presidential administration, irrespective of whether it is led by Kamala Harris or Donald Trump, would likely oppose such actions, perceiving them as currency manipulation and potentially responding with further punitive tariffs.

Therefore, Beijing can no longer rely on currency interventions as a dependable strategy.

Although the measures implemented this week could put China on a path toward long-term recovery, the current currency challenges may make the journey bumpy in the short term.

(The opinions expressed here are those of the author, who is a columnist for Reuters.)