2022: A year of restrained rise for the Chinese yuan

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Despite the divergence in the US and China’s monetary policies over the past two months – with the Federal Reserve signaling its intent to raise rates and the People’s Bank of China taking steps to cut its policy loan rate – the yuan has continued its rally against the dollar. What is driving the appreciation in the yuan? Where is the currency headed?

Trade balance and capital flows generally guide the movements of a currency’s exchange rate, with the latter having a considerably heavier bearing than the former. According to a report by the World Trade Organization, global trade volume in 2019 stood at US$25 trillion, while the daily foreign exchange transactions in April 2019 averaged US$6.6 trillion, statistics from the Bank for International Settlements showed. This means that merely four days’ worth of foreign exchange transactions would suffice to meet the foreign exchange trading demand for the entire year. As for the remainder of foreign exchange transacted, some could be used as a hedge against risks in balance sheets, or for purchasing foreign assets, but most of it is likely attributable to speculative trading.

Given that China’s capital account remains partially closed, the influence of speculative trading on the yuan’s rate would understandably be smaller.

In terms of trade, China’s foreign-currency reserve has benefited from a pandemic-driven export boom and a slump in outbound tourists in the past two years, which boosted its foreign exchange inflows, thus supporting RMB to appreciate steadily. However, with European countries and the US keeping their borders open amid the pandemic, the gradual return to normalcy will likely give rise to more demand for services, while hitting demand for goods. As such, China’s export and trade surplus will start to feel the pinch, but it will also relieve some of the appreciation pressure on the yuan.

While the numbers suggested that speculative trading could be an important factor in moving foreign exchange rates, those trades were still, to a greater or lesser extent, heeding various economic indicators – two of the key ones are inflation rates and interest rates.

The higher the inflation rate in a country, the more depreciation pressure its currency is usually under. Consider the following scenario in which Country A has higher annual inflation than Country B. Over the course of a year, the production cost in Country A will have swelled at a quicker pace than in Country B, which has lower inflation. Should Country A fail to improve its production efficiency within a short span of time, the competitiveness of its export will drop, putting Country A’s currency under depreciation pressure; on the other hand, Country B’s exports will become more competitive relative to Country A’s, thus strengthening its currency.

Year-on-year figures in December last year showed that China’s CPI (consumer price index) rose by 1.5%, the US’s by 7%, and that of the eurozone economy by 5.3%. The fact that China’s inflation rate was lower relative to Europe and the US offered a partial explanation for the yuan’s strength over the past year.

But we think that China’s inflation rate will likely remain stable over the coming six months, primarily because pork prices were hovering at elevated levels in Q1 last year. Due to the high base, there should be less inflation pressure in H1 this year. Secondly, with China’s economy at risk of a slowdown, it will be more difficult for companies to pass on rising costs to consumers.

As for Europe and the US, we think inflation will begin to taper this year as supply chain bottlenecks ease. However, due to the unprecedentedly loose monetary policies and increased government handouts in the past two years, the abundance of hot money still circulating in the economies will be an obstacle for inflation rates to fall back to the central banks’ 2% target. Instead, we think the lowest level the inflation rate will likely reach this year is around 4%.

While China’s inflation rate is still lower than that of Europe and the US, the divergence between them will likely narrow in the coming year, which should contain the appreciation pressure on the yuan.

In addition to the inflation factor, another impetus for the yuan’s surge is China’s higher interest rates relative to that of other countries. As of early February, 10-year Chinese government bond (CGB) yields stood at ~2.7%, compared to around 1.9% for US Treasuries and around 1%+ for government bonds in the euro area. Clearly, the potential returns that CGBs were offering were more attractive than their counterparts. While China is faced with pressure to cut rates this year, accelerating inflation in Europe and the US will continue to push interest rates up, while also giving the yuan some respite from the appreciation pressure.

Having considered the macroeconomic factors above – trade, inflation, and interest rates – we think the rising streak of the yuan may not come to a stop in H1 this year; but given China’s weakening exports, as well as Europe and the US’s easing inflation as they move to hike interest rates, the extent to which the yuan will appreciate should narrow compared with levels seen last year.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

Credit impulse: The “crystal ball” for investing in China

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Amid a slew of economic data flowing into the financial news every day – not so much informative as it is confusing for their audience about where global economies are headed – we’d like to share with you in today’s article what economic data points carry more weight than the others.

What’s also important is that economies and stock markets are constantly changing – data that no one paid attention to yesterday may no longer be trivial today. When we spoke of the imminent return of inflation in October 2020, many in the market were eager to brush it off. But now, inflation is on the lips of almost every investor.

The issue with economic data is the time lag, yet stock markets are traded, to a certain extent, on expectations. By the time the statistics office announces data that points to a robust economic recovery, the stock market will have already priced it in two months earlier. In that sense, not all economic data is created equal, so indicators that are forward-looking are those that warrant closer examination.

How a stock market performs mainly depends on the economy’s growth rate and the amount of capital circulating in it, but the latter is generally considered more important than the rate at which the economy is expanding. While the main driver of long-term economic growth should be sustained by improving the production efficiency of economic activities, if we are to supercharge a recovery over a short time span, the only option available to boost growth will be injecting capital to stimulate consumption and investment. As such, the abundance of capital is often a better economic indicator than the GDP growth rate is.

In a deep and mature market such as the US, the Federal Reserve could easily regulate liquidity conditions by adjusting the federal funds rate before the global financial crisis (GFC) in 2008. But even after the GFC hit, where the federal funds rate was close to 0%, the central bank could buy bonds to calibrate the amount of money circulating in the economy.

But China, as an emerging economy, and unlike the US, in which one or two economic indicators would suffice to reflect comprehensive enough a picture of the economy’s capital conditions, requires more policy tools at its disposal to regulate and fine-tune its market’s liquidity conditions. The People’s Bank of China, helpfully, publishes monthly statistics on aggregate financing in the real economy, allowing investors to get a better grasp of how much capital there was in the market in their analyses.

Aggregate financing in the real economy indicates the amount of capital that flows into the real economy from the financial system, shadow banking included, within a specific time frame. When the growth of aggregate financing in the real economy outpaces that of the GDP, it means that the financial system has put more money into the economy than needed, and that the excess is likely to flow into the property or stock markets, stimulating assets valuations.

Moreover, credit impulse – which measures the gap between net credit growth and GDP growth – can perhaps serve as a crystal ball that tells us just where the mainland economy is headed.

Historically, when credit impulse rose, both Chinese property and stock markets would also benefit, and vice versa. Since mid last year, capital growth in China has been slower than that of the economy, which explains partially why some mainland companies have been plagued by a dearth of capital available in the market, giving rise to late payment risks.

But the good news is that mainland credit impulse appears to have stabilised since September/November last year. While it is still in negative territory, the downward trend has come to a halt. With the Chinese government also slowly injecting liquidity into the market, we expect its credit impulse to start showing signs of improvement. But in terms of how much it will improve, it is going to be in this year’s monetary policy that the decision lies.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.