Why Should China Allow the Yuan to Strengthen?

TL;DR

China should allow market forces to support a gradually stronger yuan while using monetary easing and fiscal stimulus to counter low inflation. Economic resilience, changing interest-rate conditions, and year-end capital flows favor appreciation, while stronger household transfers and a broader social safety net could increase consumption and reduce precautionary saving.

Transcript

You argue that the timing is now for policymakers to allow for a stronger currency? Just tell us that in terms of the timing. Why now? Yes. Well, I think, you know, if you look at renminbi, at real effect you terms, that's what determines, you know, currencies, competitiveness. You shouldn't we shouldn't focus very narrowly on the nominal exchange ... Read More

Key Insights

• The yuan is at its weakest level since 2012 in real effective terms, having depreciated about 16% over the past ten years. Real effective exchange rates provide a broader measure of competitiveness and purchasing power than the nominal bilateral exchange rate alone.
• The dollar remains strong in real effective terms despite its index declining from 110 in January to about 100. Its continuing strength means the yuan should not be judged solely against recent nominal dollar movements when assessing China’s currency competitiveness.
• Three forces favor a stronger yuan: China’s economic resilience, changing monetary-policy conditions, and capital flows. These forces may combine near year-end as export revenues return home, supporting appreciation while still allowing two-way volatility if market conditions shift.
• A stronger yuan can coexist with higher inflation when monetary easing is paired with fiscal stimulus. The exchange rate mainly serves external balance, so it should not be treated as a standalone remedy for China’s low inflation or weak domestic demand.
• Chinese exporters can absorb modest, gradual yuan appreciation because average profit margins do not represent every company. More competitive businesses may remain resilient, while market forces distinguish stronger companies from weaker ones without necessarily causing a broad loss of export competitiveness.
• The yuan is already a reserve currency because it joined the SDR basket ten years ago, but it is not dominant. Its reported reserve share remains only about 2% to 3%, leaving substantial room for greater international use.
• Lower Chinese borrowing costs have turned a former obstacle to yuan internationalization into a potential advantage. Chinese ten-year government bond yields, previously described as 3% to 4%, were cited at about 1.8%, making yuan borrowing comparatively cheaper.
• Chinese consumption depends on income and willingness to spend, both of which reflect expectations. Consumers reportedly spend $0.66 of each additional dollar earned, down from $0.68 before Covid, so stronger transfers and social protection could reduce cautious saving.

Questions & Answers

Q: Why should China allow the yuan to strengthen now?

China should allow greater market influence because three supportive forces are converging: resilient economic fundamentals, changing interest-rate conditions, and year-end capital flows. Export revenues may return to China near year-end, while both the People’s Bank of China and the Federal Reserve face easing pressure. Together, these factors could support yuan appreciation without requiring authorities to engineer a one-way rise.

Q: Why is the real effective exchange rate important for the yuan?

The real effective exchange rate is important because it offers a broader view of competitiveness and purchasing power than a narrow nominal exchange rate. By this measure, the yuan is at its weakest since 2012 and has depreciated about 16% over ten years. The dollar, meanwhile, remains near its strongest real effective level in almost 40 years despite its recent index decline.

Q: Would a stronger yuan worsen China’s low inflation?

A stronger yuan could create deflationary pressure in a textbook framework, but it does not need to worsen low inflation if combined with suitable domestic policies. The proposed approach pairs currency appreciation with monetary easing and fiscal stimulus. Those measures can support demand and prices, while the exchange rate focuses primarily on external balance rather than serving as a universal economic remedy.

Q: How can China support a stronger yuan and higher inflation together?

China can pursue both goals by combining monetary easing with stronger fiscal stimulus instead of relying on the exchange rate alone. Fiscal expansion can lift demand and may also support interest rates and capital inflows, while monetary easing addresses financial conditions. This policy combination is presented as the route to leaving the low-inflation zone while permitting a stronger, market-driven yuan.

Q: Would yuan appreciation damage Chinese exports?

Modest and gradual appreciation would not necessarily damage Chinese exports because Chinese companies are described as highly competitive. An older argument claimed annual appreciation should stay below 3% because average exporter profit margins were only 3%, but subsequent export strength challenged that view. Average margins also conceal major differences between stronger and weaker companies, allowing market selection to operate.

Q: What would help the yuan become a more important reserve currency?

The yuan needs easier two-way market access and a larger supply of investable safe assets to become a more important reserve currency. Foreign investors should be able to access Chinese markets more easily, while Chinese residents should gain better access to Hong Kong through connect programs. China could also issue more government bonds domestically and offshore because many existing bonds remain held on institutional balance sheets.

Q: How have interest rates affected yuan internationalization?

High Chinese interest rates previously made yuan borrowing expensive for foreign issuers, creating a headwind for internationalization. Chinese ten-year government bond yields were formerly described as 3% to 4%, but were cited at about 1.8%. That decline makes borrowing in yuan cheaper. Appreciation pressure could also make yuan assets more attractive than when the currency faced persistent depreciation pressure.

Q: How can China increase household consumption?

China can increase consumption by strengthening labor income, government transfers, confidence, and the social safety net. A strong job market supports labor income, while central-government fiscal easing could help local governments restore transfers weakened by financial difficulties and falling land-related income. Broader retirement support, especially in rural areas, could reduce precautionary saving and encourage households to spend more of each additional dollar earned.

Summary & Key Takeaways

• The yuan is weak in real effective terms, while the dollar remains historically strong by the same measure. Chinese economic resilience, potential monetary-policy shifts, and year-end capital flows could reinforce one another, making this an appropriate time to permit market-determined appreciation alongside normal two-way exchange-rate volatility.

• A stronger yuan does not have to deepen low inflation if currency policy is combined with monetary easing and fiscal stimulus. The central government could support local-government transfers, household income, employment, and confidence, addressing weak domestic demand instead of expecting the exchange rate alone to solve multiple economic problems.

• Greater yuan internationalization requires easier two-way market access and a larger supply of investable Chinese bonds. Lower Chinese bond yields and possible appreciation have turned previous obstacles into potential advantages, but foreign investors still need accessible safe assets and Chinese residents need improved access to Hong Kong markets.