China FX enigma dampens stimulus optimism: Reuters’ McGeever

By Jamie McGeever

ORLANDO, Fla. (Reuters) – It’s safe to say the timing and extent of China’s stimulus this week was largely driven by the U.S. Federal Reserve’s huge interest rate cut just days before.

But unfortunately for Chinese policymakers, the US central bank’s apparent commitment to an aggressive easing campaign – and the impact this could have on the yuan-dollar exchange rate – could put Beijing in a a serious problem.

In reality, the yuan’s substantial appreciation against the dollar in the two months to Monday was puzzling. As an increasingly gloomy domestic economic outlook dragged down yields on Chinese stocks and bonds, the yuan hit a 16-month high.

And then the yuan got another boost this week as Beijing launched a series of liquidity-stimulating, monetary and fiscal measures amounting to trillions of yuan. It raised the $7.00 barrier for the first time since January 2023.

This last whoosh makes more sense. Investors are betting that Beijing is finally taking the serious steps needed to revive growth. It’s worth noting that the yuan’s rise this week has been accompanied by rising stocks and higher bond yields.

In the long run, a strong currency is good news for China. It will boost foreign investor sentiment and attract capital inflows, while boosting China’s nominal GDP in dollars – an indicator Beijing will need to focus on if it ever wants to truly rival or even surpass US.

On that note, China’s nominal annual GDP growth rate right now is lower than that of Japan and the US, something few would have predicted just a few years ago.

But the short-term picture is more complicated. As growth picks up and deflationary forces intensify, the last thing China’s economy needs is a strong exchange rate. Policymakers will welcome the renewed optimism around China, but not the strong currency that generates it.

Stephen Jen, co-founder of hedge fund Eurizon SLJ and a longtime China watcher, believes Beijing is stuck between a rock and a hard place. As the Fed’s easing cycle continues, the dollar’s peg against the yuan will almost certainly decline.

“I continue to think it’s headed lower, possibly 10% next year. Almost everyone is wrong. Positioning adjustment will make this forward-looking decline non-linear,” he wrote on Wednesday.

LIMITED OPTIONS

The People’s Bank of China is clearly powerless to stop the Fed from cutting US interest rates. So if the PBOC wants to prevent an overvaluation of the yuan, it could either lower China’s various borrowing rates or initiate a bond-buying, or “quantitative easing” program.

But it has limited scope to do the former and even less desire to do the latter. That being the case, they could use another tool to prevent the exchange rate from overheating: buying dollars.

This plan, however, carries a high political risk. China and the United States are locked in a trade war that has escalated significantly in recent years. This has deepened the political divide between the two superpowers, which is why China has reduced its holdings of US Treasuries.

China’s official holdings of US Treasuries have fallen 30% from a post-pandemic peak of $1.1 trillion in early 2021. Its total holdings of dollar-denominated assets have not shrunk nearly as much much, but the direction of travel is clear. Increasing America’s currency purchases and government debt would likely be a tough sell for Beijing domestically.

Furthermore, the next US presidential administration, whether it be led by Kamala Harris or Donald Trump, would almost certainly balk at what it would surely claim to be currency manipulation. Retaliatory action would likely follow, perhaps in the form of even more punitive tariffs.

In other words, Beijing can no longer regard bursts of currency intervention as a default confidence strategy.

So even if the steps taken this week could have put China back on the path to a long-term recovery, its currency dilemma could ensure that the road is rocky in the short term.

(The opinions expressed here are those of the author, a Reuters columnist.)

(By Jamie McGeever; Editing by Andrea Ricci)