China’s ability to implement monetary stimulus is limited as the yuan approaches a 15-year low

As China’s yuan edges closer to a 15-year low against the dollar, the country’s capacity to stimulate its struggling economy via monetary policies is increasingly constrained. In Shanghai, the yuan was trading at 7.244 against the dollar at the end of Wednesday, nearing its weakest level since last November. The situation is primarily attributed to U.S. interest rates consistently surpassing their Chinese equivalents.

The People’s Bank of China (PBOC), the country’s central bank, has repeatedly affirmed its commitment to managing drastic fluctuations in exchange rates. However, the Federal Reserve’s repeated rate hikes have pushed U.S. long-term interest rates above China’s for the first time in about 12 years, thereby limiting the PBOC’s options. Fed projections suggest two more rate hikes in 2023, potentially raising long-term rates to almost 4%. Meanwhile, China’s benchmark 10-year government bond yield hovers around 2.7%, near an all-time low. This disparity has undermined China’s ability to attract capital.

These developments are sounding alarm bells within the Chinese government, which still vividly remembers the “yuan shock” of 2015 when control over the exchange rate nearly slipped from its grasp. To counter the currency’s depreciation, the PBOC has reportedly directed lenders to slash interest rates on dollar deposits. Furthermore, state-owned institutions such as the Bank of China have reduced rates on six-month time deposits for retail customers, thus removing the incentive for depositors to trade yuan for other currencies.

Simultaneously, China is grappling with a challenging economic recovery. For three consecutive months, the manufacturing purchasing managers’ index has remained below the critical 50 mark, indicating contraction. Even though the zero-COVID policy has been abandoned, concerns over job security and income continue to linger, while a weak property market is adding to disinflationary pressure.

Despite these challenges, the PBOC is cautious about implementing significant rate cuts to stimulate the economy. It fears that such a move would broaden the rate differential with the U.S., thereby accelerating the yuan’s decline. Instead, the Chinese government is considering indirect measures like adjusting the countercyclical variable as primary tools to resist the downward pressure on the yuan. The government is reluctant to deplete its foreign exchange reserves through direct intervention.

The situation showcases a delicate balancing act for the Chinese government. On one hand, it needs to stimulate economic growth, but on the other, it must avoid a free-fall of its currency, which could trigger financial instability. Given the current global economic climate and the recent history of the yuan shock, the stakes are higher than ever, making this a closely watched issue in global financial markets.