With a strong dollar and weak yen, China faces a dilemma over where to place the yuan

The Japanese yen falls to a three-decade low, while the US inflation-fighting policy is likely to keep the dollar’s value high for some time
China’s policymakers must decide whether to restore the yuan’s competitiveness against the yen or ensure that dollar-priced goods remain affordable

Neal Kimberley

Published: 3:30am, 2 Nov 2022

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PCE. YCC. T20. These three acronyms, two financial and one sporting, might seem an odd grouping but as Beijing calibrates exchange rate policy in China’s best interests, this troika of terms has some relevance.

Faced with a situation where policymakers might well feel the renminbi is too weak versus the US dollar but rather too strong against the Japanese yen, Beijing’s options are limited. Seeking to address the first issue could exacerbate the second, and vice versa. If Chinese policymakers do wish to influence the currency markets as regards the value of the renminbi, a choice will have to be made.

A good start point in examining this conundrum is US price inflation.

The United States continues to record elevated inflation, which the Federal Reserve is seeking to rein in through tighter US monetary policy. One of the Fed’s preferred measures of US inflation is the personal consumer expenditures (PCE) price index, and in particular the so-called core PCE index, which leaves out volatile food and energy components.

Fed chair Jerome Powell pictured on July 17, 2021. It is looking increasingly likely that the Fed will raise interest rates by another 0.75 per cent in November. Photo: TNS

The US central bank keeps a watchful eye on PCE data as it seeks to fulfil its mandated 2 per cent inflation target, so Fed chief Jerome Powell and his fellow rate-setters, whose latest decision will be revealed on November 2, will have noticed that the US PCE data released last Friday remains high, despite a succession of interest rate hikes this year.

Clearly US consumers have to eat, fill their cars with petrol and heat their homes, but the Federal Reserve holds that volatile food and energy prices tend to undermine the utility of headline inflation data and so puts considerable emphasis on the core PCE price index, in its efforts to scope out the “true” US inflation picture.

Well, it’s not a pretty picture right now. Core US PCE clocked in last Friday at 5.1 per cent year on year in September, up from August’s 4.9 per cent figure and, despite the substantive tightening of US monetary policy already seen this year, way above the Fed’s aimed-for target of 2 per cent.

How China’s food security challenges shape its decision-making

Another 0.75 per cent hike in US interest rates on November 2 now looks nailed on, with an additional increase of at least 0.5 per cent to follow in December. As rising US interest rates have underpinned broad US dollar strength throughout 2022, then that bulwark of greenback strength remains in place.

But if PCE is focusing Fed minds, in Japan it’s all about the Bank of Japan’s (BOJ) continuing adherence to ultra-accommodative monetary policy, as currently exemplified in its yield curve control (YCC) strategy.

YCC currently involves the BOJ having a target for short-term interest rates of minus 0.1 per cent and being committed to keeping the yield on the benchmark 10-year Japanese Government Bond at around 0 per cent.

This stance, reiterated again by the BOJ last Friday, and more particularly the ever-widening Japan-US yield gap, has been an open goal for the currency markets throughout 2022. Indeed yen weakness against the greenback has been so pronounced, Japan’s government has recently even resorted to unilateral foreign exchange intervention to try and turn the tide.

The net result for China has been that while the yuan has weakened versus the greenback this year, it has strengthened against the yen, eroding Chinese exporter competitiveness versus their Japanese peers.

02:07

Japanese yen plunges to 32-year low as government steps in to prop currency

Confronted by this currency conundrum, Beijing may have to make a choice, and, perhaps bizarrely, a glance at what has been going on in the Men’s T20 Cricket World Cup Tournament, currently being held in Australia, may prove instructive. A number of matches at the event have either been curtailed, or not played at all, due to heavy rain.

It so happens that Hong Kong’s Women’s T20 team triumphed on Saturday in the East Asia Cup in Japan, but from China’s perspective, it’s the Australian rainfall that matters, not the cricket.

The La Nina weather phenomenon is exerting its influence Down Under and torrential rain in recent weeks in eastern Australia may well adversely affect local grain harvests. That could add to upward pressure on US dollar-denominated food prices globally, accentuating existing stress in agricultural markets linked to the continuing war in Ukraine.

China relies on imported food and Beijing attaches enormous importance to food security.

The prospect of higher US dollar-denominated grain prices might prompt Beijing to conclude its yuan policy would be better directed towards renminbi weakness against the greenback, not its strength versus the yen.

Neal Kimberley is a commentator on macroeconomics and financial markets