Don't Overthink China's Strengthening Yuan

(Bloomberg Opinion) — China may be the only major economy to notch growth at all in 2020, quite the reversal after the onset of Covid-19 triggered a historic collapse early in the year. This revival has been reflected in the yuan, Asia’s best performing currency this quarter. There’s good reason to think it isn’t a fluke.

Bloomberg Economics projects China’s gross domestic product will grow 2% this year; the Organization for Economic Cooperation and Development last week raised its forecast to 1.8%. That’s miles ahead of the first quarter’s 6.8% plunge. Recent data suggest the bounce might have staying power: Exports and industrial production have chugged away over the past few months, while retail sales rose for the first time in August since the pandemic began.

In that light, it’s little surprise the yuan has gained more than 4% since the end of June, after weakening in the first three months of the year and stagnating in the second quarter. This trend also comes amid the central bank’s relatively restrained approach to juicing the economy. The People’s Bank of China hasn’t performed the gymnastics of the Federal Reserve, or toyed with the negative interest rates that prevail in Europe and Japan, and might soon be considered in the U.K. And like many Asian currencies, the yuan has been buoyed by a weakening dollar as the Fed slashed rates and resumed quantitative easing.The PBOC is a familiar presence in markets and limits how much the currency can fluctuate in a given day. So this isn’t a pure rally the yuan is enjoying. It’s happening because the authorities are tolerating it. The central bank frets about financial instability a softening currency could bring, and has warned that ultra-loose policies pursued by developed-world central banks have had too many spillover effects. Policy makers spent the year before the pandemic worrying about the accumulation of  too much debt. (For its part, China has been known to change the rules suddenly, leading to massive gyrations across global asset classes.)

Over the years, the reason cited most often for halting or damping the yuan’s periodic appreciation has been the potential threat to export competitiveness. Until 2005, the yuan had a hard peg of 8.3 per dollar that was almost entirely about preserving the advantage of a weaker currency. As China tinkered with the system, exports gradually became less important and policy makers encouraged a shift to services, which accounted for more than half of gross domestic product by 2015. Might China, in the Covid-19 world, renew its ardor for — or dependence on — shipping stuff to the world? In the midst of an epic global contraction, it’s tempting to grab every piece of growth you can hang on to.Right now, China’s exports don’t appear to be suffering, rising 9.5% in dollar terms in August and notching the third-biggest increase ever. The current account, the broadest measure of trade, had been shrinking and was on course to disappear as a percentage of GDP. That trend looks to have been arrested, albeit temporarily. China may record a surplus of 3% in 2020, the most in a decade, according to Capital Economics. Still, it’s not inconceivable there could be too much of a good thing and the PBOC might lean against the yuan’s rise. “These days the PBOC’s aim is to smooth, not prevent, exchange rate adjustments,” writes Julian Evans-Pritchard, Capital Economics’ senior China economist.

The rest of Asia has reason to root for China’s resilience. In April, when Beijing reported its disastrous first-quarter GDP decline, I wrote that the one-time economic engine might not bail Asia out this time. Historic contractions tore through the region. But as China came to life, it began steadying some parts of neighboring economies. In Singapore, for example, exports are improving, in large part reflecting mainland demand. Beijing’s economic conflict with the U.S. hasn’t dissolved ties between Asian export hubs. A stronger currency tends to enhance the allure of imports.

If China is settling in for a protracted rivalry with the U.S., a strong currency may be appropriate. You want to attract direct foreign investment and continue opening your capital markets to international investors. The more economic stability China amasses, the bigger its gravitational pull in the region.