Here’s why you should pay attention to the Chinese yuan

The Chinese yuan is at its strongest level for over two years – and a strong yuan means higher inflation. That’s something you need to prepare for, says John Stepek.

Chinese yuan and US dollars
The Chinese yuan is now well below the ¥7/$1 “line in the sand”
(Image credit: © STR/AFP via Getty Images)

About a year and a half ago, investors were closely watching the Chinese yuan. They were worried that China might let its currency weaken drastically, rattling markets and sparking disinflation across the globe.

Now, the yuan is at its strongest level against the US dollar since mid-2018. Fears of devaluation have evaporated. What’s changed? And why should you care?

The Chinese yuan is at its strongest level in two-and-a-half years

The Chinese currency – the yuan or renminbi – has been steadily strengthening against the US dollar since about May of last year. At the start of 2020, one US dollar would fetch you nearly seven Chinese yuan. Yesterday, the same dollar would get you less than ¥6.5. That’s the strongest the Chinese currency has been since June 2018. This is significant. Not the level particularly, but the fact that the yuan is getting stronger and stronger.

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As recently as the middle of 2019, one big “macro” fear (and yes, how laughably naive that fear seems today) was that the yuan would just keep getting weaker against the US currency. Indeed, the level of ¥7 to the US dollar was regarded as a “line in the sand”, monitored with much trepidation by investors. Why?

China is trying to diversify, but it is still a big exporter. One of the biggest disinflationary factors in the world over the past two to three decades has been the presence of China as a major supplier of both labour and goods to the global economy.

Like all economies, China’s authorities face a bit of a juggling act. But that juggling act is made a lot more complicated by the fact that China is an authoritarian state with a lot of central planning. Trade-offs are hard to make when your authority relies partly on giving the impression that everything, everywhere, at all times, is going to plan. So when Chinese economic growth was under pressure amid trade disputes, one view was that the country might allow the yuan to weaken, or even push through a one-off devaluation, hoping the weaker currency would offset any trade barriers and help boost growth.

Any major devaluation of the yuan by the Chinese authorities would have sent a wave of deflation washing across the globe. Given that every central bank in the world is trying to spark inflation, that wouldn't have been welcomed by the authorities anywhere. Also, America probably wouldn’t have been overjoyed, in the midst of a trade war, to see its rival explicitly aiming to get an advantage by weakening its currency.

Anyway, the ¥7 mark drew a lot of attention because the yuan hadn’t been that weak since before the 2008 financial crisis. As it turns out, the “line in the sand” was in fact crossed. And eventually the yuan hit its weakest point in September 2019 at a point where a US dollar fetched almost ¥7.2. It rallied from there, but then the extent of Covid-19 became clear, and it started to weaken again from mid-January last year.

Then of course, Covid-19 went global, and while the yuan continued to weaken until May, by that point China was starting to recover while things were going pear-shaped everywhere else. And since then the yuan has been strengthening very consistently. So what's going on and what does it mean for your money?

What’s pushing the yuan higher?

There are few factors driving the stronger yuan. One is that Chinese assets offer much higher interest rates than US and European ones. That means China is attracting capital which will drive up its currency.

Investors have also noticed that the Chinese authorities – who still closely monitor and manage the currency – don't seem to be too concerned about its current strength. So they're more willing to bet on the currency strengthening still further. This is at least partly driven by China’s desire to deepen the country’s capital markets, which ultimately relies on being an appealing destination for capital, foreign or otherwise.

The other factor is that it’s not just about the yuan getting stronger – the dollar is also getting weaker. That’s partly because of increased risk appetite. As we've pointed out here countless times, all else being equal, a weaker dollar is good news for risk assets in general. In effect, it means that liquidity is plentiful and everyone can get hold of all the dollars they need easily (the US dollar is the global reserve currency, so everyone needs it).

The question is: what does it mean for your money? You can decide whether investing in China is something you want to do. I have my qualms – I think China is less risky than Russia in terms of respect for property rights, but that isn’t saying a great deal. And you only have to look at the slapdown Jack Ma took last year, with the scrapping of the Ant Financial IPO, to understand that when push comes to shove, the Communist party is in charge (yes, America is tiptoeing around Jeff Bezos in a similar manner right now, but both the balance of power and the institutional protections make it an entirely different matter).

That said, some smart people reckon that Chinese sovereign bonds represent a good addition to a portfolio. And there’s no doubt that China has some excellent listed companies. And at the end of the day, if China does harbour ambitions of supplanting the US as reserve currency in the future, then it’s going to struggle to do that without modernising its financial system in a way that shifts more power away from the state.

However, as far as broader markets go, the biggest point to understand about a stronger yuan is probably this: if a weaker yuan is deflationary, a stronger yuan is inflationary. A stronger yuan pushes up prices of Chinese exports, but it also enables China to buy more commodities per yuan, for example, which in turn may boost demand for raw materials even further than it already has. If China is exporting inflation, that’ll start to show up in consumer price indices before too long. That would leave the Federal Reserve in the US with a potential quandary. The Fed has said it will tolerate inflation higher than target. But how much higher?

The pandemic is still obscuring a great deal of this concern. But it’s going to become an issue, and I think one surprise for 2021 is that it will become an issue much more quickly than anyone expects. Betting on inflation for this year is not a contrarian bet, but the “reflation” trade in vogue, is fundamentally a positive, “Goldilocks” scenario. The idea is that we get higher but manageable inflation, in just the right amounts (hence the “Goldilocks” term).

The tricky thing about inflation is that it has a nasty habit of being self-feeding once it’s out there. It’ll be interesting to see what level starts to get people rattled. On that note, you should listen to our recent podcast with Russell Napier if you haven’t already.

Anyway – we’ll have more on this in the upcoming issues of MoneyWeek magazine. Get your first six issues free here.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.