In less than a month, two unusual things happened at the People’s Bank of China.
First, it no longer required banks to set aside cash if clients wanted to short the yuan. This makes betting against the currency cheaper, and allows room for the yuan to weaken. Second, the PBOC removed the so-called counter-cyclical factor, one of the three elements used to determine its daily currency fix, which guides trading. These significant tools were set up in 2015 and 2017 to stem the yuan’s free fall.
Last quarter was the yuan’s best in more than a decade. Now Beijing needs to prevent the currency from strengthening too much, particularly with the increasing odds of a Joe Biden White House. Whatever position the Democratic candidate takes toward China, his policies are certain to be more predictable than President Donald Trump’s. That would be a good thing for the yuan. In fact, currency traders had preempted policy makers, piling into the yuan as the odds of a blue wave rose.
Over the past two years, China’s currency has been whipsawed by volatile geopolitics, while traditional valuation metrics, such as the current account surplus and interest rate differentials, went to the back burner. Now that Trump appears to be on his way out, and China’s economy is growing again — with parts of Europe and the U.S. resuming lockdowns — the yuan’s outlook is rosy.
Reining in excessive currency volatility will be critical if Beijing wants to keep a steady inflow of foreign money. Lured by yield, investors abroad have been buying China’s sovereign issues at record pace, promising to overtake city commercial banks as the second largest purchasing bloc this year. If the yuan becomes a plaything for speculative traders and overshoots, long-term investors will have to worry about currency hedging and may well stop coming, especially when the market seems to believe that a Democratic victory will result in higher Treasury yields. The 2.4% interest rate differential between China and the U.S. may narrow.
Beijing needs foreign portfolio inflows right now. The government is on track to issue 3.8 trillion yuan ($568 billion) of bonds this year, almost 130% more than in 2019, according to HSBC Holdings Plc. Meanwhile, commercial banks have bought only 56% of net sovereign notes, versus 65% in 2019. Starting in June, the central bank tightened interbank liquidity to discourage asset managers from levering up on cheap loans and investing in risky financial products. Now banks are short on money.
That’s why foreigners have become the key to plugging this year’s fiscal hole. A “slow bull,” one of Beijing’s favorite slogans, offers international bond traders steady currency gains — icing on top of the yield cake.
One valid concern is whether the PBOC gave up key tools too early. But even without the countercyclical factor, the yuan fixing will still be based on two elements: the previous day’s close, as well as dollar’s movement overnight against three yuan currency baskets. Each has its own currency picks as well as weightings.
That’s a black box rife with currency-management potential. In the past, onshore traders would turn less bearish when the PBOC sent strengthening signals via the countercyclical factor, observed Goldman Sachs Group Inc. In the future, they could well take the cue from one of the baskets edging near certain key thresholds.
Looking across emerging markets, one can’t stress enough how important a stable currency is for foreign investors. Of course, China is pleased that a Biden win would unwind some of the damage Trump has done to its currency, but it doesn’t want the yuan to go on a fast track, either. China is merely getting ready for a world without Trump.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron’s, following a career as an investment banker, and is a CFA charterholder.