China should care less about its currency and more about its economy

It’s easy to forget that the world’s second largest economy is still an emerging market. China’s global influence, technological prowess in certain areas, and even low bond yields set it apart from the typical member of its asset class. But in at least one respect, China resembles a classic emerging market: it retains a palpable fear of its currency floating.

Instead, China is closely monitoring the value of the yuan against the dollar and a basket of trading partner currencies, limiting any sudden moves.

For most of the past year, she feared the yuan was floating too high. China’s largely successful effort to eradicate early variants of Covid-19 has kept its factories open and its borders closed. This allowed its exports to surge, putting upward pressure on the yuan, even as outbound tourism and imports of other services suffered, removing a source of downward pressure.

The yuan appreciated strongly against the basket of currencies of trading partners and slightly against the dollar, itself strong.

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Today, China’s fight against the pandemic is instead contributing to the sudden weakness in the currency. Lockdowns strict enough to hamper manufacturing have been imposed on Shanghai and other cities accounting for more than 9% of GDP, according to Gavekal Dragonomics, a consultancy.

China’s economic numbers for April will “certainly be dire”, he said. The war in Ukraine has contributed to outflows from Chinese bond and stock markets, as foreigners reassess the risks of investing in countries at geopolitical disagreement with the West. And as America lost its fear of the virus, its economy overheated, forcing the Federal Reserve to raise interest rates.

China's largely successful effort to eradicate early variants of Covid-19 has kept its factories open and its borders closed.

Andy Wong/AP

China’s largely successful effort to eradicate early variants of Covid-19 has kept its factories open and its borders closed.

In April, the nominal yield on ten-year Treasury bills briefly exceeded that on Chinese bonds for the first time since 2010. (Real yields remain much higher in China, where consumer price inflation is not than 1.5%, compared to 8.5% in the larger, more “mature” economies.)

A weaker yuan is both a reflection of these challenges and a way to address them. In particular, it will help support Chinese exports. But the central bank is not ready to let the currency be dominated by market forces. It bears the scars of past yuan falls, which have taken on their own momentum.

On April 25, he announced that he would reduce the amount of reserves banks are required to hold from 9% of their foreign currency deposits to 8%. This will release a few dollars in the market, easing the pressure on the yuan. The move also signals the central bank’s displeasure with the speed of its currency’s fall.

Concerns about the Chinese currency could deter the central bank from cutting interest rates to revive growth. This will leave its economy more dependent than ever on fiscal stimulus. At a meeting of the powerful Central Committee for Financial and Economic Affairs on April 26, Chinese President Xi Jinping called for more investment in infrastructure, from rural roads and urban sewers to smart power grids and power platforms. ‘artificial intelligence.

Citigroup, a bank, predicts that infrastructure spending could increase by 8% this year. But according to Natixis, another bank, China will miss its (increasingly desperate) growth target of around 5.5% unless infrastructure investment grows by almost 18%. Even a conventional emerging market with vast infrastructure needs would struggle to increase spending so much. China’s fear of floating has inhibited its monetary response to its economic woes. And that raised fears of its failure.

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