Yuan’s Resurgence Vexes Beijing

Fresh from its battle to defend the yuan last year, China’s central bank is looking at another: how to rein in its recent fast ascent.

Driven by an unexpectedly prolonged softening of the dollar, the Chinese currency has surged to around its strongest level against the greenback since its surprise devaluation in August 2015. The yuan is now on track for its best monthly performance since April 1980, rising 3% against the dollar so far in January.

The yuan’s move is roughly in line with the euro’s 3.5% gain and yen’s 3.8% gain against the dollar thus far in January. The Chinese currency strengthened 0.2% against the dollar Friday, with one dollar buying 6.3154 yuan in late New York trading.

The yuan’s resurgence is making the currency a policy headache for the Chinese government once again. If it keeps going up, government advisers and analysts say, it could encourage speculative fund flows from overseas and hurt exports amid already rising trade tensions between China and the Western world, particularly the U.S.

“This is not what the central bank would like to see,” said Xiao Lisheng, a senior economist at the Chinese Academy of Social Sciences, a government think tank, referring to the recent fast appreciation of the yuan, which is also known as the renminbi.

“The central bank wants the renminbi to move up and down according to market supply and demand,” he added. “Now it’s basically being held hostage by the dollar index.”

The central bank’s predicament shows how China still has a long way to go before it has a truly market-driven currency. In the past decade, Beijing has moved fitfully to liberalize its rigid currency regime—an effort that culminated in August 2015, when the central bank devalued the yuan by almost 2% and gave market forces more sway over the currency’s value.

But as that surprise move backfired, sending global markets reeling, China reinstated its heavy control over the yuan. Since late 2015, the central bank has embarked on a campaign to keep the yuan from weakening too quickly and to maintain confidence in the world’s second-largest economy. It subjected outbound investments to heavy scrutiny, made bets against the yuan more expensive and burned through $1 trillion in foreign-exchange reserves to support the currency.

Those strategies, helped by a weakening dollar and a rebounding Chinese economy, paid off. The yuan gained 6.7% against the dollar last year, according to Wind Info, more than erasing its loss in the prior year.

But along the way, it has remained tightly controlled and its movement has largely been propelled by how the dollar moves, not by economic fundamentals.

The People’s Bank of China—which sets the yuan’s daily official rate, dubbed the fixing—allows the yuan to go up if the dollar weakens and, conversely, lets it go down if the greenback strengthens. While predictable, this mechanism encourages one-way bets on the yuan.

A case in point: In anticipation of continued dollar weakness, Chinese exporters have been rushing to convert their dollar earnings into yuan since late last year, reversing a trend of hoarding dollars.

The current dollar-driven mechanism also means limited options for the central bank.

The PBOC did try to stem the yuan’s rise late last year by reversing a range of measures it had previously put in place to prop it up. That includes scrapping a two-year-old rule that discouraged bets that the yuan would fall in value.

This month, amid the yuan’s resurgence, the central bank tweaked how it set the fixing by halting the use of a so-called “countercyclical” factor introduced in May 2017. The PBOC had since then applied the factor in a way that helped it to curb expectations for the yuan to weaken. Now if the yuan’s continued surge results in abnormal cross-border capital flows, advisers and analysts say, the central bank could reapply the factor for the purpose of preventing it from rising too fast.

But a step like that would represent a further step back from making the yuan a market-driven currency.

“China has no shortage of policy tools to limit the yuan’s appreciation against the dollar,” said Brad Setser, a senior at the Council on Foreign Relations and a former top U.S. Treasury official. “But a lot of the most powerful tools would require backtracking on key reforms.”

Falling yuan-trading volumes so far in January suggest that the PBOC hasn’t been intervening much to stem the yuan’s rise, said Roland Mieth, emerging-markets portfolio manager at Pacific Investment Management Co. in Singapore.

The average daily trading volume so far this month in China’s domestic currency market is lower than the averages for last year and January 2017, according to central-bank data. Intervention can boost trading volumes, as the central bank instructs Chinese banks to buy or sell the yuan.

Policy makers “tend to react more to a weaker currency than to a stronger currency,” Mr. Mieth said.

Growing trade frictions with the U.S. could also complicate management of the yuan. President Donald Trump had made labeling China a currency manipulator a campaign pledge, but backed down after Beijing’s enormous effort to support the yuan last year. A weaker yuan would make Chinese goods cheaper in the U.S. market.

The lag effects of the yuan’s sharp depreciation in 2016 helped lift Chinese exports last year, with China’s annual trade surplus with the U.S. widening to a record $275.8 billion, based on Chinese data.

Going into 2018, the yuan’s surge is starting to rattle Chinese exporters and some officials. But any effort by Beijing to significantly weaken the currency could add fuel to the Trump administration’s case for tougher penalties against made-in-China products.

Sheng Songcheng, a senior adviser at the central bank, said he expects “relative stability” in the yuan’s exchange rate this year.

Many investors expect the yuan to strengthen further against the dollar, largely on their belief that the dollar’s broad-based pullback isn’t done yet. Still, some investors say they have started to hold on to their bullish yuan bets for shorter periods this year, taking profits when possible given how much the currency has already risen.

“Just because the move has been so strong, we’re happy to take some chips off the table and reduce our overweight,” said Wilfred Wee, a portfolio manager at Investec Asset Management in Singapore.

Investors and analysts, meanwhile, expect market intervention to remain a key part of the PBOC’s arsenal.

“I do expect the PBOC to remain quite involved in the foreign-exchange market,” said JC Sambor, deputy head of emerging-market fixed income at BNP Paribas Asset Management. The yuan “has never been a free-floating currency and it will not be anytime soon.”