China’s Currency Dilemma Deepens as Yuan Surges Versus Peers

  • Yuan strengthened at least 0.7% last week against euro, won
  • Allowing faster depreciation versus dollar could spur outflows

The Catch-22 Facing China's Yuan

As the yuan plumbs new lows against the dollar, China’s currency is still strengthening against peers.

That’s posing a dilemma for the nation’s policy makers as they seek to arrest a plunge in exports and shore up an economy growing at its slowest pace since 1990. China’s exchange rate climbed 0.6 percent against a trade-weighted basket last week, its biggest advance in three months, even as it slumped 0.8 percent versus the greenback to a six-year low. Against the euro and the South Korean won, the yuan gained at least 0.7 percent.

With the latest data showing Chinese outbound shipments sank 10 percent last month from a year earlier, the case for a weaker currency is growing. The quandary for policy makers is how to allow a quicker pace of depreciation against the dollar without sparking the size of capital outflows that occurred in January this year and August 2015.

"Given the current strong U.S. dollar environment, it would be difficult to see the basket weaken," said Perry Kojodjojo, a strategist at Deutsche Bank AG in Hong Kong. "At the end of the day, if you want exports to be more competitive because of your currency, then you need the currency to be weak, but the problem is that would create systemic risks, which the PBOC authorities would likely feel uncomfortable with."

Chinese policy makers had it easier earlier in the year, when fading bets for higher U.S. interest rates spurred a weaker dollar. By allowing the yuan to rise less against the greenback than its peers, the CFETS RMB Index of 13 trade partners currencies fell steadily without causing alarm. While the gauge is still down 6.2 percent this year, it’s remained above its two-year low of around 94 since Aug. 23.

The risks of a faster depreciation were laid bare in August last year, when policy makers unexpectedly devalued the currency. After a more than 50 percent surge in the real effective exchange rate over the past decade, there was a compelling case to weaken the yuan. The result, however, was panic across global markets and record capital outflows, which prompted the government to deplete its foreign-exchange reserves to stabilize the exchange rate and tighten controls on outflows.

The yuan fell 0.2 percent to 6.73 per dollar at 5:01 p.m. in Shanghai, while dropping 0.1 percent against the trade-weighted index.

Fiona Lim, a senior currency strategist at Malayan Banking Bhd. in Singapore, says 94 could be the currency basket’s low for now, with a slowdown in exports in other countries suggesting a weaker yuan may not be of much help.

"Exports remained sub-par for China and for most other parts of the world," she said. "Hence, the benefits of depreciating the yuan on a trade-weighted basis is small and would be largely outweighed by a potential rise in capital outflows should markets expect the yuan to weaken substantially."

Still, the slide in exports will add to pressure for policy makers to allow quicker depreciation, said Deutsche’s Kojodjojo.

"Given the weaker data, China is likely to try to correct some of the renminbi over-valuation," he said, using an alternative name for the currency.

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