Eco Perspectives

China: Yuan under pressure

12/15/2022
PDF

The depreciation of the yuan since the beginning of the year and portfolio investment outflows have been largely due to diverging trends in Chinese and US interest rates. They also reflect a loss of investor confidence and the deterioration in China’s economic growth outlook. Meanwhile, China’s external financial position is still very strong.

GDP GROWTH AND INFLATION

The yuan has lost 11% of its value against the US dollar since the beginning of the year, which is almost the same extent as in 2015-2016. This weakening is firstly linked to the general strengthening of the dollar, which has accompanied US monetary tightening since March.

In fact, the depreciation of the yuan in nominal effective terms has been much more moderate: the CFETS index (calculated by the China Foreign Exchange Trade System based on a basket of 24 currencies) fell by only 5% over the first eleven months of 2022. However, the weakening of the yuan has also resulted from internal factors and the dynamics of the Chinese balance of payments.

While US interest rates have increased rapidly in 2022, the Chinese authorities have relaxed (moderately) their monetary policy in order to stimulate domestic demand, in the absence of strong inflationary pressures. The spreads between US and Chinese interest rates have therefore reversed and widened, which has significantly changed international financing conditions and capital flow determinants.

Against this backdrop, China has recorded large capital outflows, in particular due to interest rate arbitrage transactions. According to balance of payments data, net portfolio investment outflows reached a record USD 159 bn in H1 2022 (-1.8% of GDP). They resulted from an increase in net portfolio outflows from residents (whose net portfolio flows are structurally negative) and from significant sales of Chinese securities (mainly bonds) by non-residents (whose net portfolio flows were negative in H1 2022 for the first time since H2 2015, and represented -0.9% of GDP). It is estimated that total net portfolio investment outflows continued (but moderated) over the rest of 2022.

CHINA: DIVERGING INTEREST RATES

Chinese enterprises that are most reliant on foreign financing (especially property developers) are experiencing difficulties in these circumstances, but the impact on China’s overall capacity to cover its external financing needs is very limited.

Firstly, because the other components of the balance of payments have performed better. In the financial account, net direct investment (DI) flows decreased but remained positive over the first three quarters of 2022; and net outflows related to debt and other investments reduced (in part thanks to the decline in Chinese credit abroad). The risk of a massive capital flight is in fact contained by the existence of controls, which have been reinforced since 2015 and are notably aimed at limiting resident capital outflows. Meanwhile, the current account surplus has continued to increase, reaching USD 310 bn over the first three quarters of 2022 (+2.4% of GDP).

Secondly, China remains little dependent on external financing despite the gradual opening up to foreign investors. Its basic balance (current balance + net DI flow) is positive, its external debt is low (15% of GDP) and foreign investors’ participation in its financial markets remains modest (they accounted for 3% of total outstanding local bonds at the end of 2021 – but 11% of government bonds – and less than 5% of equity market capitalisation). Finally, China has a very solid external liquidity position. Its foreign exchange reserves (USD 3,052 billion at the end of October) largely cover total external debt and protect against episodes of capital outflows. Foreign exchange reserves have declined only slightly since the beginning of the year, partly because the central bank’s direct interventions in the foreign exchange market to contain the depreciation of the yuan have been small. The central bank has preferred to combat currency pressure via prudential measures (such as the cut in the reserve requirement ratio on foreign currency deposits). In addition, the authorities could also be satisfied with a weaker yuan in an attempt to support the export sector.

In the short term, however, the weakening in global demand will continue to slow China’s export growth. The current account surplus is expected to fall, exerting new downward pressures on the yuan. Future dynamics in capital flows – and thus in the exchange rate – are more uncertain. The interest rate spreads between the United States and China should narrow when the US Federal Reserve interrupts its monetary tightening cycle (which is expected in Q1 2023) and assuming China’s economic growth prospects improve. However, foreign investors are likely to remain cautious, as their confidence has been weakened in the past two years by China’s zero-Covid policy, the crisis in the real estate sector, the rise in regulatory risk and geopolitical tensions.

Completed on 2 December 2022

Christine Peltier

THE ECONOMISTS WHO PARTICIPATED IN THIS ARTICLE

Other articles from the same publication

Global
Three "certainties", many uncertainties

Three "certainties", many uncertainties

From an economic perspective, 2022 will go down in history as the year in which elevated inflation made a surprising comeback forcing major central banks to start an aggressive tightening cycle [...]

Read the article
United States
United States: a recession lies ahead

United States: a recession lies ahead

US growth recovered significantly during Q3, but is expected to slow down during Q4 according to our forecasts. The labour market is still tight, but early signs of a slowdown are emerging [...]

Read the article
Japan
Japan: on the hunt for growth

Japan: on the hunt for growth

Along with the United Kingdom, Japan has had the least vigorous recovery out of all of the G7 countries during the last two years. The country even recorded a 0 [...]

Read the article
Eurozone
Eurozone: will there be a growth outage this winter?

Eurozone: will there be a growth outage this winter?

It seems highly likely that for the eurozone, 2023 will bring an easing in inflation, a contraction in GDP and a peak in the ECB’s policy rates [...]

Read the article
Germany
Germany: how intense will the recession be?

Germany: how intense will the recession be?

Unexpected to say the least, +0.4% growth in German GDP in the third quarter should not distract from the bigger picture [...]

Read the article
France
France: year zero

France: year zero

The figure zero should define French growth in 2023 [...]

Read the article
Italy
Italy: a more uncertain scenario

Italy: a more uncertain scenario

During the summer, the Italian economy continued to show a strong resilience against increasing uncertainty. In Q3 2022, real GDP rose by 0.5% q/q, benefiting from the recovery of services, while both manufacturing and construction suffered [...]

Read the article
Spain
Spain: managing new risks

Spain: managing new risks

Spain is now the eurozone country with the lowest inflation rate, standing at 6.7% in November. Government measures to curb the rise in energy prices are paying off, although the underlying CPI is still rising significantly [...]

Read the article
Belgium
Belgium: cloudy sky

Belgium: cloudy sky

Belgian GDP avoided a dip in Q3, but our present forecast suggests Q4 could be worse. A short and shallow recession looks likely as record-shattering inflation is expected to gradually abate throughout 2023 [...]

Read the article
Austria
Austria: a slump on the horizon?

Austria: a slump on the horizon?

After dynamic business activity during the first six months of the year, Austrian growth slowed very dramatically during Q3 2022, due to the economic downturn both nationally and internationally [...]

Read the article
Greece
Greece: continuing positive momentum

Greece: continuing positive momentum

Despite the significant rise in inflationary pressures, the Greek economy continued to grow quickly during the first half of 2022, at a rate of 4.1% over the period. Nonetheless, real GDP fell back 0 [...]

Read the article
United Kingdom
United Kingdom: recession

United Kingdom: recession

UK growth contracted sharply in Q3, confirming that the economy has gone into recession. Household and business surveys confirm this fall in consumption and investment, which is likely to continue in the coming months [...]

Read the article
Denmark
Denmark: the end of an impressive run?

Denmark: the end of an impressive run?

Up until now the Danish economy has continued to impress, with a strong post-Covid rebound which has propelled its GDP well above its pre-crisis level, but the future now looks a lot less bright [...]