MNI INTERVIEW: PBOC Should Be Flexible, Let Yuan Strengthen-Yu

The yuan will mainly face pressure to appreciate against the U.S dollar for the foreseeable future, but China’s central bank need not overreact and should consider increasing the flexibility of its currency management, a prominent economist and policy advisor told MNI, noting that the exchange rate is now broadly aligned with economic fundamentals.

The policy of “benign neglect” applied by the People’s Bank of China toward the exchange rate against the dollar since 2019 remains appropriate, Yu Yongding, who sat on the PBOC’s monetary policy committee from 2004 to 2006, said in an interview.

While a stronger yuan may have an adverse impact on exports, it would play a positive role in supporting China's strategic shift toward a “dual circulation” model with a focus on domestic demand and easing trade tensions, as well as promoting the currency’s internationalisation, fostering the development of financial derivatives, and ultimately improving the quality of economic growth, said Yu, now an emeritus senior fellow at the Chinese Academy of Social Sciences. (See MNI: PBOC Seen Guiding Slow Yuan Strength Amid Trade Talks)

Yu, a long-time advocate of market-oriented currency exchange rate reform, said Chinese society and market players have become increasingly accustomed to greater exchange rate volatility. Since Aug 5, 2019, the yuan has broken the 7-per-dollar mark multiple times, yet markets have responded calmly, he said, noting that China continues to record a substantial trade surplus, while in a worst-case scenario the authorities retain capital controls as a final line of defence.

Increasing the flexibility of the yuan’s management would improve cross-border allocation of resources, helping to promote current account balance and potentially reduce the need to hold low-yield foreign exchange reserves, he said. It would also enhance the independence of China’s monetary policy, provide a cushion against external shocks, and minimise opportunities for foreign exchange speculation, the economist argued.

REER DECLINE

The yuan’s real effective exchange rate (REER) has fallen significantly since the first quarter of 2022, and Yu noted that nominal depreciation has been driven by a capital account deficit and a relative decline in domestic price levels.

 Still, there is insufficient evidence to determine whether the currency has become undervalued, he said, noting that the yuan has remained relatively stable despite the absence of large-scale official dollar trading in recent years.

While a decline in the real effective exchange rate theoretically stimulates export growth, especially benefiting labour-intensive and manufacturing exporters that rely on price competitiveness, it may also increase imported inflation, Yu said.

STRONGER YUAN

Economic fundamentals mean the yuan is likely to appreciate against the U.S. dollar in the future, though bumps in the road could come from the exchange rate regime or capital controls, as well as from speculation and geopolitics, with the U.S.-China trade war a central concern, according to Yu. (See MNI: China To Test Offshore Stablecoin As U.S. Coins Spread)

Together with a substantial trade surplus, the Chinese stock market is showing signs of a gradual upward trend, attracting foreign investors, while the chances of a further significant rise in U.S. stocks are falling, reducing a major pull factor for capital outflows, Yu said.

Meanwhile, China’s demand for U.S. dollars is expected to decline. Though Chinese government bond yields are lower than those of U.S. Treasury bonds of similar duration, China is likely to continue gradually reducing its holdings of U.S. debt for asset security and geopolitical reasons, he said.

On top of all these factors, there has been speculation that U.S. President Donald Trump, who is also already trying to reshore manufacturing, might push for a “Plaza-Accord”-style deal to push down the dollar and reduce his nation’s trade deficit, Yu said.