China: Currency Policy and Expectations for 2017

Published on January 5, 2017

The Chinese Yuan, which threatened to break below the psychological 7.000 level against the dollar going into the New Year, instead has reversed and surged over the first two trading days of 2017, pulling the dollar down against major global currencies along with it.

*** Notwithstanding this sharp but welcomed correction in the Yuan weakness trend, Chinese officials believe that for 2017 the US and Chinese economies will continue to grow at divergent paces, and the US Dollar will continue to strengthen. ***

*** They do not believe CNY depreciation pressures have yet been fully released, and the State Council will tolerate an orderly depreciation of the CNY against the dollar while it stays basically stable against a basket of currencies – meaning they expect it to weaken roughly on par with other currencies vis-a-vis a broadly strengthening dollar. ***

*** Indeed, Chinese government official expects the CNY to depreciate in a gradual fashion though 2017, with the currency weakening to the 7.1000-7.2000 level, and possibly to settle somewhat weaker than that, at 7.2000-7.3000. ***

Four FX Principles

And for 2017, the Central Financial Leading Group has established the following four principles to guide FX and reserve management policy:

One – that ensuring the relative stability of FX reserves is a higher priority than defending the CNY exchange rate. In other words, the People’s Bank of China should not unduly sacrifice FX reserves to stabilize the CNY exchange rate;

Two – the PBoC should nevertheless continue to try and maintain the pace of depreciation against the dollar at a “slight” level vis a vis other major currency depreciations against the dollar, meaning the CNY should not weaken much more against the dollar than other major currencies do;

Three – the PBoC should continue reducing dollar assets as a portion of the country’s FX reserves, translating primarily into a continued sale and gradual reduction in the size of China’s US treasury holdings (see SGH 10/18/16, “China: Tonight’s Numbers, CNY, and US Rates” and also SGH 10/28/16, “China: US Protests Yuan Weakness”);

And Four – that FX reserves should in turn be invested more heavily in countries along the “One Belt, One Road” Initiative (Europe, Russia, South Asia, Southeast Asia, and parts of MENA), to the extent feasible.

Easing Currency Outflows

The Chinese Yuan had threatened to break below the psychological 7.000 level against the dollar going into the New Year, but instead reversed and surged over the first two trading days of 2017.

The massive two-day short squeeze, a record 1.5% to 2.5% rally in the on-shore and off-shore Yuan respectively, was triggered by talk that Beijing, concerned over the pace of outflows of its currency into dollars, would be encouraging its State-Owned Enterprises to convert dollar holdings back into Yuan.

Those rumors came on top of restrictions imposed by Beijing on the ability of individuals to invest their annual $50,000 FX quota overseas, and a huge squeeze in funding interest rates for holders of Yuan short positions – with Hong Kong overnight Yuan rates at one point hitting a high of 80%.

Chinese officials believe the bulk of the recent pressure on CNY devaluation has not come from foreign speculators, but from Chinese citizens. China’s domestic capital, mainly capital from private enterprise, upper, and middle class individuals, has flown through various channels into US dollars.

With the pressure stemmed from inside its borders, Beijing believes the CNY can be maintained at relatively stable rates so long as there is appropriate controls on domestic capital outflows. Hence the new restrictions.

Officials maintain the PBoC’s new, and more stringent requirements relating to large-volume cash transactions are not extraordinary, and simply bring China in line with US and other developed country standards.

They believe the new rules, serving as a warning against capital outflows, combined with an effort to crack down on corruption, tax evasion, and attempts to skirt Foreign Exchange regulations, will ensure reserves do not drop too sharply. That would be all the more so if continued improvement in Chinese economic indicators stabilize market expectations.

But Still Divergent Economies

In the big picture, however, it is clear that the number one and two major global economies – the US and China – will continue to grow at divergent rates through 2017 – and with that their respective monetary policies will diverge through the year as well.

After devaluing for three consecutive years, Chinese officials expect CNY depreciation against the dollar through 2017 to be limited, and for this year to be the last year against which the currency weakens against the US.

2018, for what it’s worth, is expected to bring in a year of modest CNY appreciation. But for now, China’s economy is still slowing, with growth trend still seen to be L-shaped at between a 6.5% to 7% growth level, while the US is picking up pace.

Officials thus fully expect dollar strength to continue, while Beijing continues to focus on potential contractionary policies broadly aimed at preventing risks, curbing bubbles, and de-leveraging the financial system.

The State Council will therefore continue to tolerate a gradually weakening CNY against the USD, even while striving to maintain its basic stability against a basket of currencies through 2017.

Indeed, one source, in a recent canvassing of officials, found that twelve of sixteen officials expect the CNY to weaken to the 7.10-7.20 level in 2017, with four expecting the currency to drop further to 7.20 or 7.30.

On a related but side note, President Xi Jinping and the central government are now urging people to stop measuring China’s GDP growth, and economic health, in US Dollars, but in local currency terms.

They note China’s GDP increased by four trillion Yuan in 2015 and another four trillion in 2016, whereas in dollar terms the economy showed no growth due to the depreciation of the yuan. In fact, they point out China’s GDP reached 70 trillion Yuan, an all-time high, in 2016.

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