Yuan at a Crossroads as Covid Outbreak Threatens Growth

(Bloomberg) -- The yuan is setting course to depreciate this year as risks to economic growth put an end to two straight years of gains.

The resurgence of Covid lockdowns and surging commodity prices are spurring doubts over China’s 5.5% growth target this year. The prospect of further monetary easing at a time when global central banks hike rates is set to accelerate outflows and further undermine the yuan. The People’s Bank of China’s tolerance for yuan strength also is wearing thin. It made the biggest push to weaken the currency through fixings last week. 

While a weaker yuan could help boost exports, a sharp decline could trigger panic about financial stability and take the shine off Chinese assets, although some strategists see that as a boon for the nation’s bonds. A global exodus from Chinese markets last week prompted a swathe of promises of support from policy makers. 

“The renminbi has passed an inflection point,” said Hao Hong, head of research and chief strategist at BOCOM International Holdings Co. It will continue to weaken, but the pace will be controlled by the PBOC, he said, adding that a weaker yuan will spread the recovery costs onto China’s trading partners and neighbors.

The yuan has fallen close to 1% in March. It still remains Asia’s best-performing currency this year with the smallest loss against the greenback that’s getting bolstered by bets that the Federal Reserve could hike rates by half a percentage point at its next meeting, if needed. 

In contrast, a median of forecasts from economists surveyed by Bloomberg shows the PBOC may cut banks’ reserve requirement ratio by 100 basis points to 10.5% by the first quarter of next year. UBS Group AG cut its growth forecast for China this year to 5% from 5.4%. Morgan Stanley now forecasts a 5.1% gain, down from 5.3% as Covid curbs weigh on the economy.

“This round of Covid-19 resurgence is likely to not only hurt services, but also industrial production and trade growth,” said Jingyang Chen, Asian FX strategist at Hong Kong & Shanghai Banking Corp. The yuan is likely to be on the back foot over the near term and may fall to 6.45 per dollar by year-end, she said. 

The dollar-onshore yuan option implied volatility indicates a 70% probability it will fall to 6.5 per dollar by the end of the year. The onshore yuan dropped 0.1% to 6.37 per dollar.

Brief Rally

The yuan jumped the most since December on March 16 on the back of a historic surge in Chinese shares as the top financial policy committee led by Vice Premier Liu He pledged to stabilize battered financial markets and stimulate the economy. A report that Saudi Arabia is seeking to price some of its oil exports in yuan also helped the advance.

However, the currency pared those gains as the average of the gap between the People’s Bank of China’s daily yuan reference rate and market estimates widened to 68 basis points last week, the highest on record since Bloomberg started the survey with analysts and traders in 2018. 

The PBOC’s weaker fixings could also be aimed at correcting the divergence in the onshore and offshore yuan, which widened last week to the most since June, a former State Administration of Foreign Exchange official said. The onshore unit is being supported by dollar selling by exporters, whereas the offshore rate is weighed by stock outflows, Guan Tao who is now a member of China FX Committee, said in an interview. 

“China’s export growth is likely to slow more notably in the second half, and a step-by-step partial border reopening – likely to begin later this year – could lead to an increase in the service trade deficit,” said Ju Wang head of Greater China FX and rates strategy at BNP Paribas SA. Wang sees yuan falling to 6.60 per dollar by year-end.

READ: Xi Signals Tweaks to Covid Strategy as Economy Under Strain

Portfolio investment from banks’ clients turned to a deficit of $32 billion in February, surpassing the previous record set in March 2020 at the onset of the pandemic, monthly cross-border flow data released Friday show. That was partly driven by a record retreat by bond investors from Chinese debt.

While HSBC’s Chen sees the yuan’s “overvaluation and reduced yield advantage” weighing on hedging behavior of corporates and portfolio investors, Australia & New Zealand Banking Group expects the real yield differential between the U.S. and China to support the yuan.

“Although the strong trade surpluses will ease later in the year, we see portfolio inflows remaining robust,” Khoon Goh, head of Asia research wrote in a note. The foreign bond outflows in February and the selloff in the onshore equity markets are temporary, he said.

©2022 Bloomberg L.P.