What a strong dollar means for foreign investors in China

The Chinese economy is showing signs of recovery and inflation isn’t a problem for the country’s central bank, unlike in the US and Europe
Given the centrality of the US dollar to the global economy, however, foreign investors buying Chinese assets need to evaluate the likely trajectories of both the yuan and dollar

Neal Kimberley

Published: 3:30am, 6 Jul, 2022

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The sight of some green shoots of economic recovery in China may well prove to be the catalyst for renewed foreign investor enthusiasm for Chinese assets. But increased demand for yuan-denominated assets may not necessarily run alongside material rises in the value of the yuan on foreign exchanges.

All foreign exchange trades are comparative judgments. Market participants weigh up the prospects of one currency against another. In the current context, as the second half of the calendar year begins, the US dollar remains strong on foreign exchanges. Other currencies, including the yuan, have been playing supporting roles.

That said, recent Chinese data suggests China’s economy is starting to pick up.

Green shoots of economic recovery may be discerned in figures released last Thursday showing that China’s official manufacturing purchasing managers’ index (PMI) rose to 50.2 in June, up from May’s 49.6, the first time it had been above 50 and in expansion territory since February.

In addition, the official Chinese non-manufacturing PMI, which reflects business sentiment in the services and construction sectors, hit 54.7 in June, in sharp contrast to May’s 47.8. Again, this was the first time this figure had been above 50 since February and it was also the fastest pace of expansion in this sector in 13 months.

Also, while acknowledging that problems do remain, the American Chamber of Commerce in China said last week that US firms operating in the country were reporting marginal improvements in business conditions.

Admittedly, green shoots don’t always take firm root but they can be nurtured, and Beijing has the policy tools at its disposal to encourage their growth.

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As Premier Li Keqiang noted recently, China has “been implementing prudent monetary policy and not printing excessive money in recent years”. Given that inflation in China is not a problem for the People’s Bank of China now, the central bank has room to provide targeted monetary policy support to the economy if required.

Those who buy into this narrative might well be tempted to purchase Chinese assets but for foreign investors, who necessarily take on an exchange rate exposure when moving from their home currency into the yuan, there is also a judgment to be made on the renminbi’s likely trajectory on the foreign exchanges.

As it is, outside China, many other major central banks, led by the US Federal Reserve, are battling inflation. The Fed is now making financial conditions more restrictive by both hiking US interest rates at pace and embarking on quantitative tightening.

Why is China’s inflation rate low compared to the US, Europe and Britain?

Given the centrality of the US dollar to the global economy, tighter US financial conditions will initially and generally translate into greenback strength, and the current situation is no exception.

As US dollar strength also tends to be disinflationary, and the primary objective of the Biden administration, as well as the Fed, is to curb US inflation, greenback resilience is probably not unwelcome in Washington at the moment.

Of course, if the foreign exchanges conclude that the Fed’s new-found zeal for tighter monetary policy risks pushing the United States economy into actual recession, then the dollar’s allure may fade.

But while broad market enthusiasm for the greenback persists, US dollar-based investors looking to purchase yuan-denominated Chinese assets might conclude that unless they hedge some or all of their exchange rate risk, any future capital gains on those Chinese investments could be eroded if, in the meantime, the yuan loses ground against the dollar.

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Elsewhere, with the European Central Bank way behind the Fed in tightening monetary policy and the Bank of Japan steadfastly still wedded to its own ultra-accommodative stance, euro-based and yen-based investors, who may be looking at Chinese asset purchases too, also have currency risk calculations to make.

If their calculation is that the US dollar will continue to perform well versus the euro and the yen, while the yuan remains relatively stable on the foreign exchanges, then those investors might well conclude that they should proceed with their investments in Chinese assets on an unhedged basis. This would enable them to benefit from any future appreciation of the renminbi against their home currencies.

Addressing exchange rate risks in cross-border investments is nothing new but what makes the current situation more interesting is the need to separate any optimistic view on Chinese economic prospects from an expectation of corresponding yuan strength on the currency markets.

In the current circumstances, it is their view on the greenback, not China’s green economic shoots, which should guide overseas investors as they purchase Chinese assets and manage the attendant exchange rate risk.

Neal Kimberley is a commentator on macroeconomics and financial markets