China’s economic recovery is bolstering yuan strength, and will continue to do so

China remains the bright spot amid global gloom, with other major economies struggling not only to contain Covid-19 but also revive jobs through stimulus
Investor confidence in Chinese assets provides solid ground for the renminbi’s outperformance

Neal Kimberley

Published: 5:25am, 7 Oct 2020

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The renminbi put in a strong showing in the third quarter of 2020. It should continue to outperform. Amid indications of China’s economic recovery from Covid-19, global investors want a piece of the action, especially when the yields that can currently be earned in China are materially higher than are achievable elsewhere.

Some might argue that Beijing won’t wish to see the yuan continue to appreciate too much further, but how far will Chinese policymakers wish to be seen pushing back against renminbi strength in the coming months?

In the United States, whether justified or not, assertions that yuan weakness can be laid at Beijing’s door always resonate across the US political divide. With a new US presidential term beginning in January, Beijing might feel that, in the coming months, it would be impolitic to lean too much against renminbi appreciation.

Already, with evidence of economic recovery in China that is less apparent elsewhere, international investors recognise that the yields currently attainable from yuan-denominated Chinese government bonds are attractive in comparison to the returns on offer in government bond markets in other major economies.

Those who are locking in these attractive yields will have noted that Beijing is making moves to allow overseas bond investors to shift money more easily into and out of China. They may also be motivated by the prospect of future capital gains.

Demand for Chinese government paper is set to burgeon late next year. FTSE Russell recently announced that, pending confirmation in March, Chinese government bonds would be phased into its flagship World Government Bond Index over 12 months from October 2021. Goldman Sachs estimates that this could result in US$140 billion of demand for Chinese government bonds during that inclusion period.

Market developments aside, it is undeniable that coronavirus-related monetary responses in economies such as the euro area and the US have been characterised by yield suppression through the adoption of increasingly ultra-accommodative policy settings.

The US Federal Reserve has tweaked its inflation target and, assuming higher consumer prices can actually be generated in future, should now tolerate inflation above 2 per cent for longer than previously might have been expected.

Despite massive pandemic-related monetary stimulus in 2020 by the European Central Bank, data from Eurostat last Friday showed annual inflation in the 19-country euro area down to minus 0.3 per cent in September, its lowest reading in over four years. Such data raises the question of whether the ECB’s current inflation target of “close to but below 2 per cent” remains appropriate.

Why the Fed’s shift on inflation tolerance could be good for China

In sharp contrast to the actions of the Fed and the ECB, the People’s Bank of China has adopted a more nuanced monetary policy approach, one that seems to have found favour with investors, and has surely underpinned demand for the renminbi.

Moreover, the PBOC’s approach seems increasingly justified by recent signs that China’s economy is on the road to recovery and in the context of Beijing’s commitment to a new “dual circulation” economic model, with its added emphasis on domestic activity. Investors will have noted that industrial production in China grew by 5.6 per cent in August, year on year, and that retail sales edged into positive territory.

Looking ahead, forecasts last month from the Organisation for Economic Cooperation and Development may only show China’s economy growing by 1.8 per cent this year, but this is far better than the OECD’s expectations that the euro area will shrink by 7.9 per cent and for a 3.8 per cent contraction in the US economy. In 2021, the OECD forecasts 8 per cent growth for China, still markedly ahead of expected expansions of 5.1 per cent and 4 per cent for the euro area and the US respectively.

As regards the pandemic itself, to the extent that markets take a view on coronavirus management in major economies when making investment decisions, it is fair to say that China appears to have had much greater success in suppressing Covid-19 than other countries – success that permits more scope for a return to some degree of economic normality.

Admittedly, there is an argument that the yuan’s rise has become somewhat overdone. US bank BNY Mellon, for example, argued last week that the renminbi was some 8 per cent overvalued.

In normal times, such a perceived misalignment might lead markets to reassess the yuan’s future prospects, but these are not normal times. The renminbi’s rise rests on solid investor demand for Chinese assets, demand that is only likely to increase in the next year or so. Yuan strength should persist.

Neal Kimberley is a commentator on macroeconomics and financial markets

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