Written by Jamie MacGyver
ORLANDO, Fla. (Reuters) – It’s safe to say that the timing and scale of the stimulus measures launched by China this week were largely driven by the U.S. Federal Reserve’s massive interest rate cut just a few days ago.
Unfortunately for China’s policymakers, however, 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 dangerous bind.
On the face of it, the significant rise in the yuan’s value against the dollar in the two months to Monday was puzzling. While an increasingly bleak domestic economic outlook sent Chinese stocks and bond yields lower, the yuan rose to its highest level in 16 months.
Then the yuan got another boost this week, as Beijing launched a series of fiscal, monetary and fiscal stimulus measures worth trillions of yuan. It crossed the 7.00 per dollar mark for the first time since January 2023.
The latter seems more logical. Investors are betting that Beijing is finally taking the serious measures required to revive growth. It is worth noting that the yuan’s rise this week was accompanied by rising stocks and rising bond yields.
In the long term, a strong currency is good news for China. It will boost foreign investor sentiment and attract capital flows while increasing China’s nominal dollar-denominated GDP — a measure Beijing will need to focus heavily on if it wants to truly rival or even surpass the United States.
In this sense, China’s nominal annual GDP growth rate is now lower than that of Japan and the United States, something that few people would have expected just a few years ago.
But the short-term picture is more complex. With growth collapsing and deflationary forces intensifying, the last thing China’s economy needs is a strong exchange rate. Policymakers will welcome renewed optimism about China, but not the strong currency it generates.
Stephen Jin, co-founder of hedge fund Eurizon SLJ and a long-time China follower, believes Beijing is stuck between a rock and a hard place. As the Fed’s easing cycle continues, the dollar’s floor against the yuan is certain to fall.
“I still think it’s trending lower, perhaps 10% next year. Almost everyone is heading in the wrong direction. Adjusting positions will make this potential decline non-linear,” he wrote on Wednesday.
Limited options
The People’s Bank of China is clearly powerless to prevent the Fed from lowering US interest rates. So, if the People’s Bank of China wants to prevent the yuan from being overvalued, it can either cut various lending rates in China or start a bond-buying program, or “quantitative easing” program.
But they have limited scope to do the former, and even less desire to do the latter. In this case, it can use another tool to prevent the exchange rate from rising: buying dollars.
But this plan carries high political risks. 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 partly explains why China has reduced its holdings of US Treasuries.
China’s official stock of US Treasuries has fallen by 30% from a post-pandemic peak of $1.1 trillion in early 2021. Its total holdings of dollar-denominated assets have not shrunk to anywhere near that, but the direction of travel is clear. Intensifying purchases of US currency and government debt is likely to be difficult for Beijing domestically.
Moreover, the next US presidential administration, whether headed by Kamala Harris or Donald Trump, will almost certainly reject what it might claim is currency manipulation. Retaliatory measures are likely to follow, perhaps in the form of more punitive tariffs.
In other words, Beijing can no longer view currency market intervention flows as a reliable default strategy.
Although steps taken this week may have put China back on the road to long-term recovery, its currency dilemma could make the road bumpy in the short term.
(The opinions expressed here are those of the author, a Reuters columnist.)
(Writing by Jamie MacGyver, Editing by Andrea Ritchie)