A more stable outlook for the Chinese yuan in 2018

The Chinese yuan is, after two tumultuous years of depreciation pressures, set to become a more stable currency in 2018. Since mid-2016, the yuan has been increasingly aligned, in varying degrees, with global and regional currency trends. Our baseline scenario favours a generalised US dollar appreciation worldwide on a more constructive US growth/inflation/monetary policy outlook, relative to its G7 peers.

The greenback’s rally, however, will start to peter out in 2H18 when other central banks position to join the Federal Reserve in lifting rates. As the US midterm elections in November 2018 nears, the odds for the Trump administration to frown on further dollar appreciation cannot be discounted.

Looking ahead, Xi has, during the 19th NC in October, pledged to push ahead with market oriented reforms of China’s exchange rate during his second five-year term that starts in March 2018.

• The official trading band for USD/CNY, currently ±2% around mid-point, may widen to promote greater flexibility in the exchange rate.

• The BRI will become more prominent in expanding the global adoption of the yuan.

• As China moves ahead to deepen and open its financial markets, its push to rebalance its economy will, however, require a gradual approach to liberalising its capital markets and increasing its capital account convertibility.

US-China trade deficit

US-led trade protectionist pressures on China will remain intense in 2018. US anti-dumping duties this year on steel pipes and tyres manufactured in China were the largest US trade action against the mainland to date. The US-China trade deficit, which widened in the first nine months of 2017, will probably be politicised during the US mid-term elections.

China’s Ministry of Commerce also reported an increase in actions from other countries – 19 countries (a 25 per cent increase) launched 88 (a 125 per cent rise) probes into China’s exports in the first nine months of 2017. Structurally, with growth slowing as the economy matures, it is perhaps reasonable to assume that trend inflation and 10Y yields would also be lower.

Since their inception in 2005, 10Y yields have in a 3.0-4.5 per cent range. Yields stayed above 4 per cent for an extended period on only two occasions – 2007/2008 (when Chinese growth was in double digits) and 2013/2014 (US taper tantrums and tight domestic liquidity).

With growth trending below 7 per cent and trend CPI probably marginally above 2 per cent, we suspect that 10Y yields should be in the 3.5-4.0 per cent range under normal circumstances.

With the People’s Bank of China still focused on deleveraging, it is likely that short-term onshore rates would be elevated, spilling over into longer-term swaps and yields. The open market operation weighted-average rate has climbed by about 25bps to 3 per cent since the start of the year. With this guidance, the 7D repo has generally been staying above 3 per cent this year.

That said, with economic momentum set to slow through the coming two years amid trend inflation, we think China government bond yields may be in an extended topping-out process. 10Y yields may briefly cross 4 per cent if investment-led growth takes hold, but that is unlikely to be sustained.