China Seeks Goldilocks Yuan To Support Liquidity

Authored by Simon White, Bloomberg macro strategist,

China has begun to push back more forcefully on yuan weakness versus the dollar, but some level of currency devaluation is required in order to keep liquidity supported.

The PBOC signaled its intention to limit further USDCNY upside by setting the fixing rate much lower than expected. Indeed, the fixing was the lowest it has ever been in relation to the Bloomberg Fixing Survey estimate in the series’ five-year history.

But it’s a delicate business.

Some currency weakness is desired in a slowdown. In a monetary system such as China’s – where domestic reserves are ultimately backed by FX reserves – capital outflow has a negative, geared impact on domestic liquidity. Currency weakness acts as a pressure valve, easing back the amount of liquidity that is destroyed.

Capital outflow from China has risen this year. Even though the country has a nominally closed capital account, necessity is the mother of all invention; capital always finds a way to leave, especially when there are dim prospects for domestic growth. We can see in the chart below, showing a proxy for capital outflow, that it has been rising, but is still lower than it was last year, or the time of the yuan devaluation in 2015.

While some currency weakness stems the outflow, too much can spur even more, causing growth to collapse. China has signaled in recent days it would prefer to see the yuan stop weakening against the dollar. Nonetheless, that is not to say they won’t want to see further weakening more broadly, as although the yuan is down 5.3% versus the dollar this year, it is down only 1.5% against the CFETS FX basket.

Furthermore, the yen’s devaluation over the last three years has considerably outpaced the yuan’s. Japan is a big a trading partner of China, and both countries compete in trading with the US. It’s very likely China would like to see the yuan weaken against the yen more. Twenty yen to the yuan appears to be an upper limit for China policymakers.

Curtailing some of the yuan’s weakness necessitates other easing measures to stabilize liquidity.

China this week cut its key medium-term lending rate. More monetary easing measures are likely in the offing, such as a cut in the RRR rate, and in the foreign-exchange RRR.

On top of monetary easing, there is soon likely to be greater fiscal stimulus too, to stabilize the property market and thus stave off a debt-deflation, and to support consumption and thus reinvigorate growth.