China Grapples With Yuan Messaging Amid Inflation Pressures

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China’s central bank has sought to clarify that it won’t let the yuan strengthen too much, too quickly, as mixed signals from officials underline the challenges presented by a currency trading near a three-year high.

The exchange rate will remain “basically stable,” the deputy governor of the People’s Bank of China said in a statement on Sunday. Earlier, another central bank official wrote that the yuan should appreciate to offset the higher costs of commodity imports. That essay, published in a state-backed magazine on Friday, has since been deleted. Separately, another official said China has to give up its control over the exchange rate eventually to achieve greater global use of the yuan.

With factory-gate prices surging, a stronger yuan helps reduce the cost of imports, such as commodities -- a key component of inflation. Yet any sign that Beijing is encouraging gains in the currency may spur traders to bet on further appreciation, triggering capital inflows that could inflate asset bubbles.

On Tuesday, the PBOC set its daily reference rate -- which limits moves in the onshore yuan by 2% on either side -- at a level that was weaker than analysts and traders had forecast. It has set the fixing at weaker-than-expected levels on all except three days this month, suggesting its tolerance for a strong currency is fading.

China Grapples With Yuan Messaging Amid Inflation Pressures

“The PBOC has a higher tolerance for strength in the yuan, but that doesn’t mean it wants to see major capital inflows or outflows, any directional trend or large volatility,” said Becky Liu, head of China macro strategy at Standard Chartered Plc. in Hong Kong. “That’s why, when it thinks the supply and demand of the yuan is imbalanced, it will use the fixing to manage expectations.”

The yuan has gained 2.2% this quarter, making it one of the best performers in Asia. The rally has been fueled by weakness in the dollar, which is near a three-year low. Capital inflows helped to quicken the gains, as overseas funds bought yuan bonds that will be included in global indexes and offer more attractive yields.

China has long been resistant to one-way appreciation in its currency, which has become a key concern after foreign investors boosted their holdings of onshore stocks and bonds by nearly 70% in the year through March.

Read more about China’s markets here:
China Targets ‘Speculators and Hoarders’ to Stop Commodity Boom
China Braces for $1.3 Trillion Maturity Wall as Defaults Surge
Official Call for Rising Yuan Is Deleted: What to Watch in China
Analysts See Stable Yuan Beneficial for China: Sec. Journal

An appreciating local currency also makes Chinese exports less competitive. “The main risk of such a strong yuan is that it hurts exports, and as such, it hurts exporters and therefore producers in the same way as high commodity prices,” said Iris Pang, chief economist for Greater China at ING Bank NV.

The PBOC is doing more than sending verbal signals and setting weak fixings. The authorities also boosted the quota for onshore investors to buy overseas assets in January and March, reflecting Beijing’s willingness to see more capital outflows. The onshore yuan gained as much as 0.3% to 6.4030 per dollar, the strongest level since June 2018, on Tuesday.

“The yuan will have room to gain further in the near term as the dollar remains weak,” said Tommy Ong, managing director for treasury and markets at DBS Hong Kong Ltd. “But the PBOC will likely manage expectations when the rally is too quick.”

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