Monetary policy and real estate challenges to Chinese yuan

Erik Norland November 15, 2021 09:03

Over the past three years, the Chinese Yuan (CNH) has strengthened against most emerging market currencies while tracking closely to currencies such as the euro (EUR) and British pound (GBP). CNH fell against the U.S. dollar (USD) in the two years after the U.S. began placing additional import tariffs on Chinese goods before rebounding as the pandemic began.

In essence, CNH behaves like a developed market currency and its value closely tracks those of the chief buyers of China’s exports. Although China’s economy is sometimes lumped into the “BRIC” category, it barely resembles those nations. Unlike Brazil and Russia, China is a manufacturing center and not an exporter of commodities. In contrast with India, China relies on heavy industry rather than services.

Monetary Policy

Like most currencies, the yuan appears to strengthen in response to tighter monetary policy and vice versa. The People’s Bank of China’s (PBoC) primary tool for changing monetary policy is the reserve requirement ratio which it adjusts more frequently than it does interest rates . Over the past 25 years, CNH has tended to strengthen versus USD following increases in PBoC reserve requirement ratio and tended to fall versus USD after PBoC relaxes the ratio.

Growth gaps

China’s economy has grown much faster than the U.S. economy – or for that matter just about any other economy -- over the past several decades. However, the gap between China’s pace of growth and that of the U.S. has been anything but constant over time. China’s pace of growth accelerated versus that of the U.S. between 2005 and 2010, and the Chinese currency rallied sharply versus USD, with its rally extending into 2013. In 2011, China’s pace of growth began to slow, both outright and relative to the pace of growth in the U.S. The process of relatively slower Chinese growth continued right up until the onset of the pandemic and China’s currency slid versus the U.S. dollar on and off between 2014 and early 2020.

In early 2020, China went into lockdown before any other country, producing the only negative quarter of GDP growth in its recent history. By Q2 2020, China was coming out of lockdown and recovering at the same moment as the U.S. economy was just starting to be severely impacted by COVID. CNH rebounded sharply versus USD during this as the growth gap moved back in China’s favor.

For the moment, growth gaps are difficult to read statistically. Year-on-year growth rates are now heavily influenced by base effects– what was happening last year rolling of the fourth-quarter GDP window. That said, the U.S. and China’s period of extreme divergence on growth rates may now be coming to an end. Both countries are more or less in the same boat. COVID-19 is endemic around the world. The spread of the Delta variant may slow recovery in the U.S. China has been able to control the spread of the virus and is more prone to regional lockdowns to control fresh outbreaks. Both countries’ are suffering from supply chain disruptions and higher energy costs.

What is interesting about the growth gap is that it appears to have been a useful indicator of where CNH is going, sometimes even years in advance.

Inflation and the Future of Monetary Policy

Thus far in 2021, U.S. inflation rates have been surging. The same has not been true in Asia. While South Korea’s inflation has perked up a little, inflation in China and Japan remain at low levels. This means the PBoC may continue easing monetary policy even if the U.S. Federal Reserve (the Fed) considers raising rates in 2022 or 2023.

The PBoC often tightened lending standards following periods of high inflation and eased them after periods of low inflation. Chinese inflation is not without upside risks. Shortages of coal and natural gas have sent their prices soaring and triggered electrical blackouts in parts of China which could exacerbate supply chain problems. Central banks do not treat those kinds of supply disruptions as reasons to tighten monetary policy. Rather they tend to view them as being transitory.

If China’s debt levels, real estate situation and low inflation rates convince the PBoC to continue its current course of easing monetary policy, that could lead to a weakening of CNH versus USD. This might be especially true if a Chinese monetary policy easing coincides with a Fed rate hike. If consumers shift spending back towards experiences and away from manufactured items that might also slow China’s export growth, reducing the currency market’s focus on net exports and refocusing on monetary policy to the possible detriment of CNH.

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Erik Norland

Senior Economist, CME Group