DDespite a slowdown in the Chinese economy, a drop in the reserve requirement rate for loans (RRR) and the disruptive events around Evergrande, the Chinese exchange rate rose against most currencies in 2021. Reflecting the China’s currency strength, China’s trade-weighted exchange rate index hit its highest level since 2015 (see chart).
A notable feature of the USD / CNH during 2021 was the fact that in the middle of the year, the USD / CNH deviated from its long-term trend with the USD index. The USD index rose, but the USD / CNH fell, reflecting the strength of the CNY (see chart).
The strength of the Chinese currency in 2021 partly reflects the large inflows of bonds and, to a lesser extent, the inflows of equities in China. Foreign bond holdings of Chinese bonds reached their highest level since 2007, equivalent to nearly 4.0% of total Chinese government bonds issued.
Foreign investors were drawn to the high yields on Chinese real bonds (adjusted for inflation). While the real yield on US ten-year bonds fell deeply into negative territory to hit over -6.0%, the real yield on China’s ten-year bonds remained positive. The 10-year bond differential between the US and China has fallen to all-time lows of around -6.20%, guiding USD / CNH to 3.5-year lows by the end 2021 (see graph).
The depreciation of the USD / CNH started to stabilize at the end of 2021 after the occurrence of two important events. First, the Chinese authorities have raised the reserve requirement ratio (RRR) for foreign currency deposits from 7% to 9%. This meant that Chinese banks were required to hold 9% of their foreign currency deposits with the central bank (PBoC) rather than having those foreign currency deposits available for use in other areas, including foreign investment. . This was the second increase in RRR by Chinese authorities in 2021. Chinese authorities appear to have taken this policy decision regarding the RRR of foreign currency deposits after foreign currency deposits in China hit a record high of $ 1 trillion. dollars (see graph).
Second, the USD / CNH also started to stabilize in late 2021 after the PBoC started to steadily increase the USD / CNY daily benchmark rate. The higher USD / CNY daily benchmark rate implies that the Chinese authorities can use their discretion within the designed tolerance levels of the USD / CNY daily benchmark rate, to weaken the CNY against the USD. This does not guarantee that the USD / CNY will advance higher. However, in the past, such activities have sent a signal that the Chinese authorities do not want their exchange rate to appreciate too much. Reflecting the possibility that USD / CNY could move higher, USD / CNH started trading higher than USD / CNY, having previously traded below USD / CNY.
It is understandable that the Chinese authorities do not want their exchange rate to be too strong. China’s CPI inflation is not very high, especially compared to other major countries. Inflation in China is not turning out to be a major concern. This means that the Chinese authorities do not need a strong exchange rate to ease local inflationary pressures from the CPI. What would be more politically desirable would be a slight weakening of China’s exchange rate to encourage stronger export growth and stronger employment growth.
Calendar year 2022 will be an interesting one for the USD / CNH. A number of factors suggest that the strength of the CNH seen in the second half of 2021 and much of 2021 will not persist into 2022. However, despite China’s historically high real exchange rate and, therefore, the China’s export competitiveness put to the test, China’s current account surplus remains strong at 2.0% of GDP. A healthy current account surplus suggests that it will not be easy for China’s exchange rate to weaken materially, and for the USD / CNY to advance significantly higher without any particular catalyst.
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