What makes China's yuan "unprecedentedly" strong?

Chinese 100 yuan banknotes in Beijing

At the moment, the Chinese yuan (CNY) is doing better against the US dollar even as the US Federal Reserve (Fed) prepares to raise interest rates. So what is the reason for this phenomenon?

According to the CFETS RMB Index, an index that tracks the yuan's performance against 24 other currencies, the value of China's domestic currency has increased by more than 8% in 2021 and is only 0.26% below its previous record high set in November 2015.

The yuan has also strengthened against the dollar. It has gained 2.4-2.8 percent this year, and whether traded within China or overseas, the yuan is at its highest level against the dollar in at least three years.

The offshore yuan exchange rate is currently at 6.34 yuan/USD, a level not seen since May 2018.

The yuan's gains in 2021 were "the best in the world," according to Marc Chandler, CEO of Ohio-based financial trading firm Bannockburn Global Forex.

Booming exports and hot money chasing relatively attractive returns from Chinese government bonds are behind the yuan’s rise “despite weak economic growth,” according to Becky Liu, head of China macro strategy at Standard Chartered Bank.

Experts say the currency's strong gains could continue into 2022, even as China's economy grapples with issues such as inflation, a property slowdown and an ongoing regulatory overhaul targeting the country's private sector.

Liu expects the yuan to strengthen to 6.3 yuan per dollar early next year, while analysts at Goldman Sachs say the same could happen in the first half of 2022 for the same reasons.

Earlier in 2014, the offshore yuan hit nearly 6.01 yuan per dollar, its highest level since China launched a landmark currency revaluation in 2005.

As the yuan strengthens, central banks will increase their reserves of the currency, thereby promoting its use globally. In addition, a stronger domestic currency also makes imports cheaper and curbs rising inflation.

However, there is a big downside to a currency that appreciates too quickly: a more expensive currency makes exports less competitive abroad. For an export-dependent country like China, this could threaten the already fragile recovery of the world's second-largest economy.

Strong exports are a “support”

China’s economy has been hit in recent months by disruptions to international shipping and a deepening domestic property crisis. An energy crisis, which has since eased, also contributed to the economy growing at its weakest pace in a year in the third quarter of 2021.

Despite this, China’s exports have continued to perform well. The value of shipments from China reached $325.5 billion in November 2021, up 22% year-on-year. Exports in the January-November period rose 31% to more than $3 trillion — more than the entirety of 2020.

Analysts attributed the result largely to increased demand for Chinese goods as the world recovers from the COVID-19 pandemic. China, which has taken a hands-off approach to the COVID-19 pandemic, has also largely avoided the disruptions other exporters in the region have experienced due to the SARS-CoV-2 outbreak.

Larry Hu, head of China economics at Macquarie Group, said the main reason for the yuan's appreciation was the amount of money flowing into China, largely due to strong exports.

He said it was likely that exports would remain strong even as the world responded to the Omicron variant of the SARS-CoV-2 virus.

Attractive yields attract hot money to government bonds

Another reason for the yuan's strong rally, analysts say, is the interest of international hot money in Chinese government bonds.

According to the People's Bank of China (PBoC, the central bank), the value of yuan-denominated bonds held by international investors increased for the eighth consecutive month in November 2021, reaching 3.9 trillion yuan (equivalent to 620 billion USD).

Global investment flows into Chinese bonds have accelerated after FTSE Russell, a global index provider, added Chinese government bonds to its flagship World Government Bond Index in October, one of the world's most widely used global bond benchmarks.

Analysts at ANZ bank expect the move by FTSE Russell to help Chinese government bonds attract about $130 billion in investment over the next three years, and estimate that foreign investors will own $4 trillion worth of yuan-denominated bonds ($625 billion) by the end of this year.

“Concerns about short-term growth risks (in China) will not deter foreign investors from increasing their asset allocation to the Chinese market,” ANZ analysts wrote.

Global investors are also chasing "attractive" returns from Chinese government bonds, according to these experts. Currently, China offers a 10-year yield of 2.9%. For comparison, the US Treasury's similar yield is 1.44%.

Stabilizing the rise of the yuan

In the context of the strong appreciation of the yuan, there are opinions that China may intervene.

The PBoC announced on December 15 that it would raise the required foreign exchange reserve ratio from 7% to 9%, the second increase this year. The move will force Chinese financial institutions to hold more money in reserve and could be interpreted as a way to curb the yuan’s rise.

This is one of the strongest signals yet that the central bank is feeling uncomfortable with the pace of the yuan’s appreciation, Gaurav Garg and Philip Yin, two analysts at Citigroup, wrote in a report released on December 17.

The PBoC warned last month that financial institutions and companies should refrain from “speculating” on the yuan. Analysts said the regulator was concerned that a strong yuan would hurt the competitiveness of Chinese goods in the world. Financial markets could also be disrupted by rapid capital outflows if the currency appreciated too quickly.

“In our view, the Chinese authorities would like to see the yuan stabilize,” said Liu of Standard Chartered Bank. However, he said the likelihood of authorities “directly intervening in a heavy-handed manner,” such as directly buying dollars and selling yuan, was low.

According to this expert, one or two US interest rate hikes could help cool the yuan's heat, as China implements a reverse monetary policy to boost growth.

“We still expect the yuan to continue to appreciate, but at a much more gradual pace,” Goldman Sachs analysts wrote in a research report last month.

According to Tin Tuc newspaper