FX & Y: Yuan step at a time

It has become a cliché to say that America and China operate on entirely different historical timescales—but sometimes clichés contain a grain of truth. As Donald Trump meets Xi Jinping this week, talk has turned to the possibility of a currency accord, akin to the Plaza Agreement of the 1980s, in which China agrees to let the renminbi appreciate. Anyone expecting an immediate breakthrough would do well to remember that Beijing measures progress in decades, not news cycles.

On paper, the renminbi looks firm, trading near a nominal three-year high as today’s state banquets get underway. China no longer intervenes as crudely as it once did, and the Treasury Department has declined, in its recent reports to Congress, to label it a “currency manipulator”.

Yet the apparatus of control remains firmly in place. Beijing sets tight trading bands for the yuan and, when markets threaten to breach them, deploys state-owned banks to absorb foreign currency. Adjusted for inflation and trade weights, the renminbi has fallen more than 13% since early 2022 and remains roughly a fifth* below where fundamentals suggest it should be, suggesting that authorities are working to keep it undervalued.

A cheap currency is not the free lunch it appears. By keeping the renminbi artificially weak, Beijing subsidises its exporters at the expense of almost everyone else. Chinese consumers find imported goods dearer than they should be, suppressing household purchasing power and reinforcing the economy's lopsided dependence on manufacturing and exports over domestic consumption. Capital, meanwhile, is drawn towards tradeable industries not because they are the most productive, but because the exchange rate makes them artificially profitable. The result is chronic overinvestment in factory capacity that the world does not need and underinvestment in services and consumption that China's own people do. In the short run, the strategy flatters gross domestic product numbers and keeps politically-important factories humming. In the long run, it deepens the very imbalances—anaemic consumption, industrial overcapacity, vulnerability to trade shocks—that Chinese policymakers claim they wish to fix.

If a weak renminbi stores up problems, a rapid appreciation would bring them forward all at once. China's export sector employs tens of millions of workers in industries where margins are thin and pricing power is scant. A sustained rally would render swathes of this capacity uncompetitive almost overnight, threatening a wave of factory closures and job losses that would land hardest in regions already grappling with the fallout from the property bust. The financial system would absorb the shock unevenly: banks with heavy exposure to export-dependent borrowers would see non-performing loans spike, at a moment when balance sheets are already stretched. There is also the speculative danger. A currency perceived to be on a one-way path upward becomes a magnet for hot money, driving appreciation beyond what the economy can absorb and setting the stage for a painful reversal. China's policymakers need only look to Japan in the late 1980s to see how a well-intentioned currency accord can curdle into an asset bubble and a generation of stagnation.

The likelier path, then, is the one Beijing has almost always preferred: gradual, tightly managed, and deliberately unpredictable. A slow appreciation of the renminbi would allow exporters time to adjust, either by moving up the value chain or by shifting production to lower-cost countries where Chinese firms increasingly operate. It would gently boost the purchasing power of Chinese households, supporting the long-promised rebalancing towards consumption without delivering the shock of a sudden revaluation. Crucially, it would let the authorities retain control. By punctuating any upward trend with occasional sharp reversals—engineering sudden dips that burn anyone betting on a smooth ride—Beijing can wrong-foot any speculators who might otherwise pile into one-way bets on appreciation. It is the exchange rate-policy equivalent of two steps forward, one step back—or, as the great reformer Deng Xiaoping liked to put it, “crossing the river by feeling the stones”.

For now, the world will have to live with the distortions created by Beijing's management of the renminbi. Because persistent surpluses in one country mean persistent deficits in others, imbalances in the global economy are likely to keep widening—putting pressure on political systems everywhere and sparking deeply-unpredictable moves in foreign exchange markets.

A grand bargain to address all of this is not impossible. But it will arrive, if it arrives at all, on Beijing's schedule, not Washington's. American presidents measure progress in weekly polling averages and 24-hour newscycles. China measures it in decades. That gap is not closing any time soon.

- Karl Schamotta, Chief Market Strategist, Karl.Schamotta@Corpay.com

*Note that calculating currency valuations is not an exact science, particularly when the data are opaque and subject to differing interpretations. In China’s case, a range of measurement methods, including purchasing power parity calculations, behavioural and fundamental equilibrium exchange rate models, and the IMF’s external balance assessment model all point to undervaluation, with the clearest real-world evidence coming from the country’s extraordinary trade surpluses, which amount to a significant share of global gross domestic product.