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January 13, 2022

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On decoupling the yuan and the dollar

In the past, US dollar and Chinese yuan used to move inversely. Recently, that has not been the case. Dollar is appreciating, and so is yuan. Are the bilateral currencies decoupling? In its report, Chinese business journal Caixin has traced the decoupling back to September 2021.

The relationship between the yuan and the dollar has been relatively consistent since the mid-2010s, as measured by the US Dollar Index (DXY). The Index reflects the value of the dollar relative to a basket of currencies of America’s major trading partners.

However, the current divergence is not the first of its kind. It was preceded by another in the mid-2010s, when the Fed began its gradual exit from ultra-low rates. The dollar soared until the self-induced double-whammy: that is, US trade wars and pandemic mismanagement.

The yuan’s recent appreciation has been explained on the basis of China’s strong export performance. Yet, imports grew even faster. Export growth has slowed on the back of a stronger yuan, and weakening demand due to the Omicron wave and higher costs.

Decoupling has been reinforced by strong capital flows, thanks to the encouragement of foreign direct investment (FDI) and further opening of capital markets.

Even if the Fed’s rate normalization will reduce capital flows to Chinese markets, the continued opening of China’s financial sector may offset some of the pressure. FDI into China is also likely to be resilient, due to capital inflows from the Belt and Road and ASEAN economies.

Bumpy normalization

What complicates assessments of potential dollar-yuan decoupling is the impact of pandemic uncertainty on monetary policies and rates.

Last October, the PBOC stated it was phasing out the use of the countercyclical factor. A more hands-off stance toward the exchange rate fosters appreciation.

As China’s central bank has signaled, the yuan may face a rougher ride in 2022, due to normalization by overseas central banks.

In December, the Fed indicated it would end its pandemic-era bond purchases in March, thus paving the way for two to three interest rate hikes by the end of 2022. Yet, the Omicron surge fosters new pandemic uncertainty. After the new year, the US reported almost 1.1 million new daily COVID-19 cases, a new global record.

When the Fed in 2008 opted for ultra-low rates and rounds of QE, it took a risky path that has sucked it into a money-printing quagmire.

And the Chinese yuan? In 2022, it will face centrifugal pressures but fundamentals do not warrant disruptive changes.

The yuan is propelling emerging currencies unlike ever before.

In the longer-term, US dollar and Chinese yuan will decouple. In the short-term, uncertainties reign.

Dr. Dan Steinbock is an internationally recognized strategist of the multipolar world and the founder of Difference Group. He has served at India, China and America Institute (US), Shanghai Institutes for International Studies (China) and the EU Center (Singapore).


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