How China Manages Its Currency—and Why That Matters
It isn’t just about economics. The yuan has a political and psychological importance too.
China’s approach to its currency is a mix of bold ambition and fear of dollar strength.
The yuan has lost more than 3% of its value against the greenback this year and was doing even worse before the dollar slipped against most global currencies in November. The yuan traded around 16-year lows against the dollar in September. A dollar now buys around 7.15 yuan.
A weak currency should be good news for an economy that is sometimes called the world’s factory floor. China exported around $3.7 trillion of goods and services in 2022, more than any other country, according to World Bank data. A weaker yuan makes Chinese products cheaper to the rest of the world, which should boost demand. But that is only half the story.
China’s currency has a political as well as economic importance. The U.S. labeled China a currency manipulator in 2019, escalating a trade war between the two superpowers. China has had ambitions for years to promote the international use of its currency, presenting a long-term challenge to dollar dominance.
The value of the yuan is also seen by many people inside and outside the country as a sign of confidence in China’s economy, which is suffering from a moribund real-estate market, a slowdown in manufacturing and a reluctance by consumers to spend big. Foreign investors have pulled out of China’s stock markets this year, and small investors in the country are nervous.
“The central bank’s worry is that currency weakness will exacerbate negative sentiment among foreign investors and domestic ones,” said Alvin Tan, head of Asia foreign-exchange strategy at RBC Capital Markets.
This all means that the yuan is almost certain to remain in the spotlight next year. Here is a guide to how China manages its exchange rate.
The yuan is really two currencies
Beijing operates a novel currency system that combines an onshore yuan and a more freely traded offshore version.
The People’s Bank of China allows the onshore yuan’s value to be dictated by market forces—within limits. Each morning, the China Foreign Exchange Trade System, a unit of the central bank, publishes a reference rate for the yuan against a variety of currencies, although the dollar rate gets most of the attention. It is then allowed to trade 2% above or below that level during the day. The offshore yuan trades without restrictions.
The gap between the two exchange rates offers a sign of how far the market’s perception of China’s economy—and the value of its assets—is diverging from the official view. In October, the difference between the offshore and onshore yuans spiked due to a surge in U.S. government bond yields and rising concerns about China’s economic slowdown.
“While the currency has stabilized, the gap itself is an indication that the market is still not really gung ho, not too sure about the currency and by extension, the economy,” said Sim Moh Siong, a currency strategist at the Bank of Singapore.
The central bank has a lot of tools
The central bank has taken multiple steps to prop up the value of the yuan this year, including allowing banks to hold less foreign currency in reserve and making it harder for them to buy dollars.
One of the PBOC’s most closely watched policy tools is where it sets the onshore yuan’s daily reference rate against the dollar, known as the fixing. From late June to November, the fixing was consistently set at a stronger yuan rate than market participants expected. That sent a clear signal that the central bank wasn’t willing to let the currency plunge to new lows against the dollar this year, said Ju Wang, head of Greater China foreign-exchange and rates strategy at BNP Paribas.
The currency’s weakest point this year was in September when a dollar bought around 7.36 offshore yuan.
The central bank uses something it calls the discretionary countercyclical factor, a number it adds to—or subtracts from—its idea of the fair daily fixing to push back against large moves in the market. The PBOC has kept quiet on whether it has used the factor this year, but after a long period of stronger-than-expected fixings, many strategists think it has.
Chinese authorities take a less formal approach in the offshore market. The government and state-owned enterprises issue yuan-denominated bonds in Hong Kong that suck up liquidity, and sometimes state-owned banks wade into the market to reduce the supply of offshore yuan, supporting the currency, according to analysts.
But it also has bigger fish to fry
The easiest way for central banks to boost the value of their currencies is to raise interest rates since higher rates lead to more demand for assets in a country, which in turn boosts demand for the currency. But the PBOC has cut rates this year in an attempt to prop up the faltering economy.
That has exacerbated the impact of the historic rise in U.S. interest rates. U.S. government bonds now offer much higher yields than those in China, a major reason for the yuan’s poor performance against the dollar this year. But the pressure is easing. In November, foreign investors scooped up yuan-denominated bonds again, partly driven by expectations of lower U.S. rates.
Economists increasingly think the U.S. Federal Reserve is done with its campaign of interest-rate increases, and the dollar has recently weakened against a variety of currencies as a result. That is helping bolster confidence at China’s central bank, which is allowing the market to influence the currency more, said Craig Chan, global head of foreign-exchange strategy at Nomura. That includes setting daily fixings that track market expectations more closely.
Still, a more hands-off approach by the central bank may just lead to more yuan weakness, said Chan.
China has bold ambitions for the yuan
The dollar is the world’s global reserve currency and is on one side of around 90% of foreign-exchange transactions, according to the Bank for International Settlements. This gives the U.S. a huge advantage over other countries, sometimes referred to as the “exorbitant privilege.” China has taken steps to erode that advantage, attempting to promote the use of the yuan across the world.
Foreign banks already accept offshore yuan deposits, and their customers can use this money to buy yuan-denominated stocks and bonds outside of mainland China. Chinese leader Xi Jinping has been courting governments in the Middle East and pushing them to accept yuan payments for oil. Russia already accepts yuan for some of its oil shipments.
The yuan was the world’s fourth-most used payment currency in value terms at the end of November, overtaking the Japanese yen for the first time since January 2022, Swift data shows. The Chinese currency was used for around 4.6% of payments, the result of a multiyear rise and its largest share since Swift started compiling the data in 2010.
But it is going to be a long time before the dollar is under threat. The greenback was used for around 47% of the world’s payments in November.