Sure A Not

No government is probably happier that the US Federal Reserve is completing the most aggressive tightening cycle in decades than Xi Jinping’s.

Amid intensifying headwinds zooming China’s way, the idea of less monetary austerity in Washington – and fewer shocks in global capital markets – couldn’t arrive sooner. And odds are that Wednesday’s Fed interest-rate increase, the 11th in 17 months, is the last in the current campaign.

Yet there’s another reason the Fed taking a breather is comforting news for Xi: It relieves pressure on the yuan exchange rate.

As investors ratcheted down their expectations for China hitting 5% growth in recent weeks, the central bank found itself in a tug of war with currency speculators. Local media detailed how China’s major state-owned banks were dumping dollars for yuan in onshore and offshore markets to halt the renminbi’s slide.

This week, the plot thickened as top Community Party leaders meeting in Beijing pledged to keep a floor under the yuan exchange rate as part of vows to invigorate the capital market and buttress confidence.

“It’s interesting that the Politburo mentioned FX stability in the statement, for the first time in recent years,” analysts at HSBC observe in a note to clients. “This means that smoothing yuan depreciation pressure may become more of a policy priority from now on. This is in line with the People’s Bank of China’s further tightening of FX policy recently.”

On the dollar’s recent strength, strategists at RBC Capital Markets note that “the current rise has not been accompanied by as sharp a spike in volatility.” Thanks to nimble policymaking, they add, the yuan’s recent softness hasn’t turned “into an acute crisis situation.”

Beijing limiting the yuan’s downside is good news for four reasons.

One, it reduces default risks in the property market.

It’s not a given that Fed chairman Jerome Powell is done raising rates. As economist Seema Shah at Principal Asset Management puts it: “Data dependence remains the buzzword and, given the confusing signals of waning inflation but a tight labor market, keeping all options on the table seems to be a sensible approach” for the Fed.

Powell, after all, is keeping his options open after Wednesday’s move to raise the Fed’s benchmark rate to roughly 5.3% from 5.1%, the highest level since 2001. As Powell said on Wednesday, “it’s certainly possible that we will raise rates again at the September meeting. And I would also say it’s possible that we would choose to hold steady at that meeting.”

Longtime Fed watcher Diane Swonk at KPMG speaks for many economists when she says Powell’s directive was “about as clear as mud.”

What is clear, though, is that the steady decline in US inflation over the past year – to 3% from 9% – means the Powell Fed will soon take a back seat on US economic policymaking.

As the Fed throttles back on austerity, monetary-policy currents among top economies will remain uniquely divergent for the rest of 2023. It means that the conditions that propelled the dollar to the highest in decades are being reversed just as China is struggling to support the yuan.

As downward pressure on the yuan recedes, so will concerns that “China Evergrande” will be trending on global search engines. The weaker the yuan gets, the greater the risk property-development giants might default on dollar-denominated debt.

Quieter conditions in Chinese credit markets will make it easier for Xi’s reform team to end boom/bust cycles in the real-estate sector.

Two, it reduces the risk of an Asia-wide race to the bottom on exchange rates.

In recent months, many Asian policymakers worried the yen’s 7% drop this year would prod Beijing to follow suit. Nothing, after all, might ensure China reaches this year’s 5% GDP growth target faster than a sharp drop on the yuan.

That would set the stage for a region-wise response. Given still-lingering trauma from the late 1990s, fears that Tokyo’s beggar-thy-neighbor strategy might provoke responses from China to South Korea to Southeast Asia has been a major fear of US Treasury officials.

Back in the ’90s, the Fed’s aggressive rate increases boosted the dollar to levels that forced officials in Bangkok, Jakarta and Seoul to abandon currency pegs. Those competitive devaluations set in motion the 1997-98 Asian financial crisis.

In the decades since, governments strengthened banking systems, increased transparency, created bigger and more vibrant private sectors and amassed sizable foreign-exchange reserves to shield economies from global shocks.

The Covid-19 crisis, though, demonstrated that Asia is still too reliant on exports for growth. Even so, Asian governments over the past year have been more inclined to prop up exchange rates to limit the risks of imported inflation.

As Xi and Premier Li Qiang resist the urge to engineer a weaker yuan, the global financial system has breathed something of a sigh of relief.

Three, a stable yuan could help reduce trade tensions. Surely, it has dawned on US Treasury Secretary Janet Yellen that Beijing is displaying restraint in currency levels as Tokyo does the opposite. That might have been the reason Yellen’s team left China off Washington’s latest “currency manipulator” lists.

Even if Prime Minister Fumio Kishida’s Japan is pushing the weak-yen envelope, Beijing needs to tread carefully. As President Joe Biden runs for re-election, Republican challengers – many itching to investigate China over Covid-19 and suspicious of Asia in general – are sure to accuse Beijing of unfair currency manipulation.

Sanctioning China is, after all, perhaps the only thing on which Biden’s Democrats and Republicans agree. Xi’s team surely realized that while Donald Trump’s trade war and unhinged rhetoric were a drag, Biden’s more targeted and consistent curbs on China Inc since January 2021 have landed some notable blows.

All the more reason to avoid new tensions just as Premier Li’s team pivots toward creating greater economic space for China’s private sector to thrive. Part of the problem is China’s own success in de-emphasizing the public sector over the last 20-plus years.

Sure, Xi’s regulatory clampdown on Big Tech since late 2020 stymied progress on increasing the role of – and innovation in – the private sector. But Beijing is being reminded the hard way that the public sector’s share of urban employment – roughly 20% – no longer packs the punch it once did. It means that, this time, Xi and Li need a more vibrant private sector to boost income and confidence on the way to faster GDP growth.

Here, the policy shifts on display in Beijing this month, coupled with a less draconian Fed, are a plus for private-sector development in Asia’s biggest economy.

“This latest rhetoric from the top man of China’s State Council is likely to boost positive animal spirits in the short term at least,” says analyst Kelvin Wong at Oanda.

“From a medium-term perspective, the external environment also needs to be taken into consideration when global interest rates are likely to stay at a higher level for at least till the second half of 2024 given the latest hawkish monetary policy guidance from major developed countries’ central banks,” including the Fed.

Four, it suggests the shift to more productive growth is real. The latest signals coming out of Beijing are that Team Xi is more focused on long-term economic confidence than short-term-stimulus sugar highs.

The strategy “talks about boosting consumption but only indirectly, via supporting household incomes,” says Julian Evans-Pritchard, head of China economics at Capital Economics. “Those hoping for a new approach to stimulus involving greater transfers to households are likely to be disappointed.”

Economists at Barclays add that “while it signaled more support for the economy, the Politburo meeting generally fell short of offering large-scale stimulus. We view this as a signal that the government would stabilize growth around its target but refrain from an outsized policy response, given the top leaders’ intended shift in focus to quality.”

With a weak-yen obsession these last 25 years, Japan has amply proved that a weaker exchange rate may boost GDP, but does nothing to increase innovation, productivity or overall competitiveness.

If you are the CEO of a large or midsize company, why bother doing heavy lifting on restructuring, recalibrating, reimagining or reanimating innovative spirits when a weak exchange rate is bailing you out?

At the same time, internationalizing the yuan has arguably been Xi’s biggest reform victory these last 10 years.

In 2016, Xi’s government set the stage for yuan’s fast-increasing use in trade and finance when then-PBOC governor Zhou Xiaochuan secured a place for the yuan in the International Monetary Fund’s Special Drawing Rights program. It marked the yuan’s inclusion in the IMF’s club of reserve currencies, joining the dollar, euro, yen and pound.

Xi’s team has steadily increased and broadened the channels for foreign investors to access mainland China’s stock and bond markets. Chinese shares were added to the MSCI index, while government bonds were included in the FTSE Russell benchmark. That, and moves to increase financial transparency, increased global demand for the yuan.

Odds are good, says analyst Ming Ming at Citic Securities, that Xi’s government will continue to improve China’s capital-markets infrastructure to attract more long-term investment and boost direct financing.

Part of the process of building trust in the yuan is letting markets decide its value. The lack of full convertibility remains a big speed bump, of course. But so would the perception that Xi’s team and the PBOC are actively manipulating the yuan lower – provoking the Biden White House or the wider Group of Seven.

Beijing is focused on maintaining progress to date in internationalizing the yuan, and for good reason. That will get a bit earlier as the Fed ends a tightening cycle that Xi’s Communist Party will not miss.

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