China's Yuan Face Much Tougher Road in Rest of 2017

Tighter controls on capital outflows were bolstered by a less-welcoming attitude toward Chinese foreign direct investment in Europe and the U.S.

The yuan may soon hit a wall.

Photographer: SeongJoon Cho/Bloomberg

Looking at the performance of China’s currency this year, one would suspect that things are looking up in the local economy. The reality is that the yuan’s 4.5 percent gain against the dollar is as much a reflection of weakness in the U.S. currency as it is about developments in China. At this point, what investors should expect for the rest of the year is a roughly stable yuan, or one that strengthens at a much slower pace. 

To understand how the yuan got to this point, consider that Chinese foreign-exchange reserves have been expanding for the past six months, reaching a nine-month high of $3.01 trillion. Behind that increase sits better trade balance surpluses, which increased for five straight months as a result of stronger growth among China’s main trading partners as well as some deceleration in Chinese imports since the end of last year. Second, Chinese controls on capital outflows appear to be effective. Overseas mergers and acquisitions by Chinese companies fell 43 percent in the first half of 2017 from the same period of 2016. Chinese overseas property investment declined 82 percent.  

The effect of tighter controls on capital outflows was reinforced by a less welcoming attitude towards Chinese foreign direct investment in Europe and the U.S. The likelihood of the U.S. invoking Section 301 of the 1974 Trade Act to impose sanctions on China for violating U.S. intellectual property rights and the mandatory sharing of technology by U.S. companies operating in China has risen considerably. Section 301 authorizes the U.S. government to investigate foreign government acts or policies that “burden, restrict, or discriminate against United States commerce.” The president can then act unilaterally to impose tariffs or other trade restrictions. An executive order by President Donald Trump that prompts an “investigation” of China’s trade practices could come out as soon as this week, the timing of which coincides the heightened U.S.–North Korea tensions.    

Although China is not yet fully addressing its economic imbalances and much needed debt restructurings -- and unlikely to do so until President Xi Jinping’s political power is consolidated following the 19th National Congress of the Communist Party this fall -- it is trying to slow the unsustainable expansion of debt and credit. It is doing so mainly by regulatory methods, with little or no tightening of monetary and credit policy using standard central bank instruments such as interest rates, open market operations, changes in reserve requirements, and the like.

Chinese authorities will likely continue to target credit and asset market excesses selectively, using regulatory and administrative control, or direct controls on the sectoral or industrial allocation of credit. This means that there will be continued -- haphazard -- measures to control credit going into the markets for residential real estate and ceilings on housing prices. It will also mean further attempts to control credit coming from the shadow banking system. 

Conventional monetary policy instruments -- such as the seven-day reverse repo rate, the one-year deposit rate, and the one-year loan rate -- are unlikely to be changed in the near term. Only the seven-day reverse repo rate is now an actively used instrument, with increases of 10 basis points in February and March. The loan and deposit rates have not been changed since October 2015. Simply put, there is no domestic reason to raise rates with inflation under control. 

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