ETF Trends
ETF Trends

China is increasingly top of mind for investors. Bulls see an opportunity in a massive equity rally. Bears are focused on a slowing economy, a potential real estate bubble and a related surge in debt. But as covered in a new BlackRock Investment Institute paper, “Climbing China’s Great Wall of Worry,” there’s another dimension to China’s economic evolution: the currency.

The direction and footprint of the Chinese yuan, or renminbi as it’s also known, is important not just for investors in China, but also for the global economy. China is the world’s second largest economy, and its currency is becoming more ubiquitous in international trade. Recently, the yuan became one of the top-five currencies for global payments, overtaking the Canadian and Australian dollars, according to interbank association SWIFT.

Given the yuan’s expanding role, what’s the outlook for China’s foreign exchange market and currency? Here’s my take, including why I don’t think the yuan is poised to overtake the greenback in popularity anytime soon.

The Chinese government will continue to move toward financial liberalization. As part of a broader move toward reforming the economy, the Chinese government has publicly committed to opening the capital account by the end of the year, meaning money would be able to move more freely in and out of the country. A potential intermediate milestone to watch: later this year the yuan may be added to the International Monetary Fund’s (IMF)’s Special Drawing Right (SDR) basket of currencies. In order to meet the IMF criteria, a currency must be “freely usable,” i.e. convertible.

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Instead of steady appreciation in China’s yuan, expect a two-way market. From 2011 through early 2014, the Chinese government managed a persistent and steady appreciation of an undervalued yuan. However, over the past 18 months, we’ve seen more of a two-way market. Investors should expect this to continue, as there are contrasting factors impacting the currency. As China moves toward more of a consumption-led economy, its current account surplus should shrink over time. In addition, increasing capital outflows indicate that the currency may be too expensive. Both factors suggest the potential for renewed weakness. That said, China still posts a sizeable current account surplus, roughly equivalent to 3.5% of gross domestic product (GDP). The country also has an extremely high savings rate, which should support the currency. In short, expect more volatility in the yuan.

The yuan won’t replace the dollar anytime soon. While China will ultimately move toward full convertibility, the government will be cautious in terms of timing and implementation. Even when China does take this final step, it will be many years before the yuan represents a serious threat to the dollar’s hegemony. Even with the recent growth in adoption, the yuan accounts for just 2.2% of global payments versus 45% for the dollar. Furthermore, China still has far to go in developing its capital markets, particularly its debt markets. This is a key criteria if a country aspires to reserve currency status.

For investors, there are a number of takeaways. First, given that the dollar is likely to remain the world’s currency for many years to come, it will continue to provide support to U.S. assets, particularly bonds. In the process, it will help keep interest rates lower than they otherwise might be.

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