China’s exchange rate policy favours a stable renminbi. However, the positive factors that have boosted the Chinese currency are turning negative, leading to views that the renminbi should weaken in 2022.
The supportive factors include an expected decline in China’s current account surplus and a narrowing yield spread and economic growth differential relative to the developed markets. Furthermore, the renminbi’s trade-weighted exchange rate has risen to a historic high (Exhibit 1), raising the risk of official intervention to keep it from rising further and hurting Chinese exports.
Arguably, the market has discounted these factors since early 2021, so they should not affect the renminbi’s exchange rate. Furthermore, the eroding yield-spread argument may not matter much as the real yield spread between China (and other Asian economies) and the US has remained so large that even moderate US interest-rate increases may still leave China with a comfortable rate buffer (Exhibit 2).
Politically, Sino-US trade talks may produce a reduction in some tariffs. These cuts may come indirectly in the form of tariff exclusions for selected Chinese exports. This could be a boost for renminbi sentiment that has not yet been discounted in the price, in our view.
Meanwhile, new dynamics could produce other positive surprises for the renminbi in the coming year.
Omicron and the balance of payments
Another factor is the new Covid-19 variant. Omicron, and any other evolving virus strains, could boost China’s current account surplus and, thus, the renminbi in 2022, ceteris paribus. We note that the market has been wrong since 2018 about China’s current account falling into a structural deficit. 
As we have argued recently, Beijing is likely to keep its zero-Covid policy in place at least until the National People’s Congress in March 2022.  Thus, mobility will remain restricted and this should delay China’s consumption recovery and curb demand for imports. Coupled with the expected weakening of commodity and energy prices in the coming year, this policy will reduce the value of China’s total imports.
In general, constantly evolving virus strains could prolong China’s export strength if new variants keep production in other countries from normalising and consumption from switching from goods to services.
New strains will also likely delay the opening of China’s borders, shrinking the contributions from tourism and education to China’s services trade deficit by barring Chinese tourists and students from going abroad. A shrinking services trade deficit should help improve China’s current account surplus (Exhibit 3).
Tools for curbing renminbi strength
However, Chinese policy does not favour further currency appreciation. The strength of the renminbi’s trade-weighted exchange rate will eventually damage exports, and that negative impact will intensify as and when other countries can normalise production and consumption. The People’s Bank of China will likely step up its efforts to limit the renminbi’s appreciation if the upward pressure does not abate.
In our view, the odds of heavy-handed direct intervention are low because currency strength in 2021 has been driven largely by fundamentals, with a rising basic balance  backed by a current account surplus and inflows of long-term capital rather than market speculation.
The narrower spread throughout 2021 than in 2020 between CNY-USD and CNH-USD implies that there are few speculative forces, especially in the unmanaged offshore market, driving a wedge between CNH-USD and CNY-USD.
The central bank has other tools at its disposal to curb the renminbi’s strength:
- Raising the foreign currency reserve requirement ratio for onshore banks. This will have a strong signalling effect on curbing currency speculation by reducing USD supply, raising USD interbank rates and, thus, the cost of short-selling USD against CNY. The central bank raised this ratio by 200bp to 7.0% in June, and it can do that again at its discretion.
- Tightening the net open position (NOP) of onshore financial institutions. This is a limit, typically ranging from USD 50 million to USD 2 billion, on financial institutions’ ability to take long or short positions in the onshore currency market. The authorities can curb speculation on renminbi appreciation by reducing the limits on banks’ ability to hold net short USD positions.
- Expanding capital outflow channels for mainland Chinese to invest overseas. These include programmes for Qualified Domestic Institutional Investors (QDII), Qualified Domestic Limited Partnerships (QDLP) and, most recently, Southbound Bond Connect and Wealth Management Connect.
Eventually, as production and consumption normalise around the world and rising inflation further erodes the real yield spread between China and the developed markets, the strength of the renminbi may well abate.
However, considering the other factors analysed here, there is a possibility that the renminbi’s overall strength may still surprise the market and boost the total returns on investing in China.
 See “Chi on China: The Fuss About China’s Current Account Deficit and Global Cost of Capital”, 17 April 2019
 See “Chi Time: China’s Zero-Covid Policy – Timing, Benefits, Costs and Impact”, 24 November 2021.
 Approximated by the sum of the current account balance and net FDI flows