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The risk of yuan depreciation doesn't seem to be troubling investors any longer, with the currency having been on a gradual upward trend for about three months.
The central parity rate of the yuan was set at 6.6633 per US dollar on Wednesday, according to the China Foreign Exchange Trading System.
There is a correlation between the appreciation of the yuan and the rise in China's foreign exchange reserves. The reserves rose for a sixth straight month to $3.08 trillion in July - up 0.8 percent from the previous month - as the yuan's exchange rate held relatively stable.
According to the unrevised balance of international payments statement recently released by the State Administration of Foreign Exchange (SAFE), China's cross-border capital outflows eased in the first half of 2017. It seems the combination of a weaker yuan and the massive capital outflows in the second half of 2016 and earlier this year has been completely reversed.
Given the changes in China's economy, the New York Times suggested in a recent report that "it might be time to start selectively relaxing cross-border curbs, if Beijing wants to attract more foreign money into (its) stocks and bonds." However, we believe that SAFE won't follow that suggestion. Although there is less pressure on China when it comes to capital outflows and yuan depreciation, we don't foresee that capital controls and restrictions on foreign exchange will be relaxed anytime soon. The most likely scenario is that it will still take some time for the government to decide on easing control over the capital account, because the financial situation is not yet stable in the eyes of Chinese policymakers. In addition, it is too early to say that capital inflows will persist.
It is necessary to be prudent about the yuan's latest round of appreciation and careful study what caused it. A stronger yuan, which doesn't add to evidence of a possible economic upturn, is to some extent merely a reflection of the US dollar's weakness.
Although the US economy has had a relatively good performance, investor confidence has been weighed down by political uncertainty surrounding the administration of President Donald Trump. More and more investors believe the US economy is not yet on track to live up to his commitments, which will result in further capital outflows from the US in search of safe-haven assets.
In addition, there has been an increase in risk aversion among investors amid tensions between the US and North Korea, leading to an accelerated capital outflow from the US and further depreciation of the US dollar.
However, a look at the Chinese market clearly reveals that China's economic growth doesn't support a rapid, substantial yuan appreciation. Therefore, domestic market participants need to keep cool-headed over the strengthening of the yuan, which has primarily resulted from the US dollar's decline. Another point to note: both the domestic and overseas capital markets unanimously expect the Chinese currency to continue rising. This means at least in the short term that virtually no one wants to short the yuan. Nevertheless, the economic fundamentals don't justify the yuan's meteoric rise. Investors should be alert for volatility.
Further, the yuan's fast rise has not been entirely a boon for the Chinese economy. A rebound in exports helped bolster the economy in the first half, but if the yuan strengthens too much against the US dollar, China's exports will be affected. According to Anbound's estimates, if the yuan strengthens to 6.6 against the US dollar, the fundamentals of the economy will keep the Chinese currency from rising further. At that point, the risks of excessive strength will gradually emerge.
In conclusion, it's optimal for China keep the yuan basically stable amid appreciation expectations. Too much movement in either direction would augur ill for the market. In particular, if the yuan rises too far too fast, the risks may do likewise.
