CIO Viewpoint: China’s long march to an internationalised yuan

China is poised to become the world’s largest and most powerful economy. In line with that status, the country needs a free-floating yuan that positions itself as a reserve currency. This would undoubtedly further improve the integration of Chinese capital markets in the global financial system.

Reactions from China’s authorities to contain the recent coronavirus with quarantines, business shutdowns and travel bans will undermine the country’s first-quarter growth. This economic damage is being met with monetary and fiscal measures, including a 1.2 trillion yuan (USD 172 billion) injection into the financial system and 300 billion yuan in credit to commercial lending banks. The Chinese authorities may also signal a more expansionary fiscal policy at the National Party Congress (NPC) in March.

We will see indications of how effective those measures have been when China reports first-quarter GDP in mid-April. For now, we expect the first quarter’s real gross domestic product to be the lowest reported in China’s modern history, at around 4% (see chart 1). That would be consistent with the impact of SARS in 2003, and, similarly, assuming the virus is contained before long, we see this as a one-off shock. As a result, we expect growth to recover as early as the second quarter, to reach 5.5% for the full year.

It is notable that China is not reacting to the virus by adjusting its long-term strategy for the yuan. It will not want its efforts to contain the outbreak to affect its carefully managed, floating currency. As we go to print, the number of coronavirus infections continue to rise, and had reached more than 40,000 by 10 February, with 910 deaths, all but two in mainland China. We are watching closely the daily net rise in infections, as well as measures of media coverage that 17 years ago during the SARS epidemic provided an indication that cases had peaked.

The scale of China’s response to the coronavirus, which appears to have a mortality rate in line with other influenzas of around 2%, has been unprecedented with more than 50 million people quarantined. Last week, 11 days after starting building work, and in a highly publicised demonstration of the economy’s ability to mobilise resources, a 1,000-bed hospital opened doors to its first patients in the city of Wuhan, the coronavirus’ epicentre.

‘Managed floating rate’

The country’s transition towards a more market-oriented currency began almost 15 years ago. In July 2005, China removed its peg to the dollar, revaluing the renminbi by 2.1% and allowing a “managed floating rate” against an undefined basket of currencies. In July 2008, during the financial crisis, China again pegged its currency to the dollar before returning in 2010 to a managed floating rate. The central bank then devalued the yuan and widened its trading band in a series of steps before the International Monetary Fund (IMF) added the renminbi, in October 2016, as the fifth currency (along with the US dollar, euro, Japanese yen and British pound) to make up its Special Drawing Rights. The IMF’s SDRs can be used as a reserve asset, positioning the yuan as a more credible part of the global financial system.

However, in contrast to the IMF’s other SDR currencies, the People’s Bank of China (PoBC) fixes a mid-point for the onshore yuan (CNY) and allows it to trade within a 2% band either side of this level. The offshore yuan, or CNH, trades in Hong Kong, Singapore, New York and London, in smaller volumes than the CNY. The PBoC has worked to make this daily fixing mechanism more market oriented and understandable to the public. Since 2010, China has encouraged the use of the yuan in trade settlement, including the launch two years ago of the first yuan-denominated crude oil futures. More recently, China has pushed to increase the use of the currency in capital account transactions, giving investors more access to onshore assets such as bonds and equities.

The approach earned a further boost when Chinese bonds were added to the Bloomberg Barclays bond indices in 2016, and in April last year, when government and bank securities were added to the Bloomberg Barclays Global Aggregate, Treasury and Emerging Market Local Currency Government indices. Other emerging market benchmark providers such as the FTSE WGBI and JP Morgan are still considering adding China to their bond benchmarks.

Yet despite offering diversification, low correlation to other markets and lower volatility, according to MSCI, foreign investors still own only 2% of the Chinese onshore bond market. And taking into account international issues, foreigners still only own 7% of the Chinese sovereign bond market.

Scaling ambition

Above all, China knows that its economy needs more efficient and stable currency markets to cut the costs of international trade and reduce exchange rate risks. This approach goes hand-in-hand with China’s “One Belt, One Road” initiative that aims to place the country at the centre of a pan-Eurasian economic hub.

The recent trade tensions with the US, settled for now with a ‘phase 1’ truce in December, have underlined the growing global dependence on the Chinese economy. Despite posting its slowest growth in gross domestic product last year, four years from now China will account for 19% of the world’s GDP, compared with 17% today, estimates the IMF. China’s purchasing power overtook the US six years ago and will be one-and-a-half times greater than the US by 2024. The country is home to seven of the 20 biggest internet companies by market value, including Tencent, Alibaba, Baidu and Ant Financial, and its domestic bond market is the world’s second largest after the US.

The MSCI added Chinese stocks to its global benchmarks in 2018 and last year said it would quadruple China ‘A’ shares to one fifth of the index, adding an estimated USD80 billion of foreign inflows. By adding large- and mid-cap China ‘A’-share companies in 2019, China’s weight in the MSCI Emerging Markets Index rose to around one third, from about 28% in 2017.

Containing the coronavirus

In response to higher tariffs imposed by the US since mid-2018, the currency weakened past the level of 7 yuan to the dollar for the first time since 2008, triggering the US Treasury to label China a “currency manipulator.” As part of December’s trade truce, and in response to China’s falling trade balance with the US, the US dropped this largely symbolic label.

Usually, one would expect weaker activity and easier monetary policy to lead to a weaker currency. However, we believe that China’s travel shutdown to contain the virus within its borders will lead to some improvement in China’s services deficit. In recent years, large tourism-related outflows have coincided with downward pressure on the yuan. For this reason, a fall in outflows may in fact support the currency, even as it will hurt the Thai, South Korean and Singaporean currencies whose economies depend on Chinese tourism.

Portfolio positioning

Our portfolio is well positioned to weather the current market volatility. We are underweight in allocations to equities, overweight in allocations to carry strategies and hold hedges in gold and US Treasuries.

The recent volatility in Chinese markets now offers opportunities, and we have implemented a forward position in the yuan, which we think is backed by the easing trade tensions with the US and the wider decline in the dollar that we anticipate this year. Concretely, since the US trade truce in December, the Chinese central bank’s dollar/yuan fixings look too high relative to the dollar, and, coupled with the decline in tourist outflows, we expect the yuan to strengthen. For these reasons, we have initiated a 4% long position on the offshore yuan against the dollar, with a target price of 6.70.

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