Column-China’s FX conundrum dampens optimism on stimulus policy: McGeever by Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) – It’s safe to say the timing and size of the stimulus measures China unleashed this week were driven in large part by the U.S. Federal Reserve’s massive rate cut just a few days earlier .

But unfortunately for Chinese policymakers, the US central bank’s apparent commitment to an aggressive easing campaign – and the impact it could have on the yuan-dollar exchange rate – could spell serious trouble for Beijing.

At first glance, the yuan’s substantial appreciation against the dollar in the two months through Monday was staggering. As an increasingly bleak domestic economic outlook pushed down Chinese stock and bond yields, the yuan rose to a 16-month high.

And then the yuan got another boost this week, as Beijing rolled out a series of liquidity, monetary and fiscal stimulus measures running into the trillions of yuan. The country has raised the limit to 7.00 per dollar for the first time since January 2023.

This latest whoosh makes more sense. Investors are counting on Beijing to finally take the serious steps needed to revive growth. Notably, the yuan’s rally this week has been accompanied by rising stock prices and higher bond yields.

In the long term, a strong currency is good news for China. It will boost foreign investor sentiment and attract capital inflows, while increasing China’s nominal dollar-denominated GDP – a metric that Beijing will need to focus on if it ever truly wants to rival or even surpass the US.

In that respect, China’s nominal annual GDP growth is currently lower than that of Japan and the US, something few could have predicted just a few years ago.

But the short-term picture is more complicated. With growth slumping and deflationary forces increasing, the last thing the Chinese economy needs is a strong exchange rate. Policymakers will welcome the renewed optimism around China, but not the strong currency it generates.

Stephen Jen, co-founder of hedge fund Eurizon SLJ and longtime China watcher, thinks Beijing is between a rock and a hard place. As the Fed’s easing cycle continues, the dollar’s bottom against the yuan will almost certainly fall.

“I remain convinced that the stock is headed down, possibly 10% over the next year. Almost everyone is wrong. Adjusting positioning will make this expected decline non-linear,” he wrote on Wednesday.

LIMITED OPTIONS

The People’s Bank of China is clearly powerless to stop the Fed from cutting US interest rates. So if the PBOC wants to prevent an overvaluation of the yuan, it can either cut Chinese interest rates or initiate a bond-buying program, or “quantitative easing.”

But it has limited ability to do the former, much less the desire to do the latter. If so, it could use another tool to keep the exchange rate from overheating: buying dollars.

However, this plan entails a major political risk. China and the United States are engaged in a trade war that has escalated significantly in recent years. This has deepened the political rift between the two superpowers, which is partly why China has reduced its holdings of US government bonds.

China’s official stock of U.S. government bonds has fallen 30% from a post-pandemic peak of $1.1 trillion in early 2021. Total holdings of dollar-denominated assets haven’t shrunk nearly as much, but the direction the country is moving is clear. Ramping up purchases of U.S. currency and government debt would likely be a tough sell for Beijing at home.

Furthermore, the incoming US presidential administration, whether led by Kamala Harris or Donald Trump, would almost certainly shy away from what it would certainly allege as currency manipulation. Retaliation, perhaps in the form of even tougher tariffs, would likely follow.

In other words, Beijing can no longer view bursts of currency intervention as a reliable default strategy.

So while the steps taken this week may have put China back on the path to long-term recovery, the currency issue could make the road bumpy in the short term.

(The views expressed here are those of the author, a columnist for Reuters.)

(by Jamie McGeever; editing by Andrea Ricci)