FX speculators drive China’s yuan to 17-year lows

As 2025 begins, few central bank peers envy the tug of war facing People’s Bank of China Governor Pan Gongsheng.

Pulling from one side are currency traders betting Beijing will respond to Donald Trump’s coming trade war with a weaker yuan. On the other side, is Chinese leader Xi Jinping, who until now has opposed engineering a lower exchange rate.

This week, Pan’s team signaled anew its support for a stable yuan by setting its daily reference rate even stronger than the psychologically important 7.2 per dollar level. It did so in response to the yuan dropping past 7.3 per dollar.

Though the yuan is trading at 17-year lows, the downward pressure on exchange rates extends much wider than Beijing. On Monday (January 6), most major Asia region currencies slid as the US currency traded at two-year highs.

“Trump’s trade policy plans are driving renewed expectations of a stronger-for-longer US dollar,” writes BMI, a Fitch Solutions company, in a note. “This has the potential to send prices lower” in China.

Along with “Trump trade” dynamics boosting the dollar, traders are responding to hints from the US Federal Reserve that rate cuts may be few and far between in 2025.

For one thing, US inflation isn’t receding as rapidly as hoped. For another, the American labor market continues to display unprecedented vigor even as global headwinds intensify.

None is bigger than underwhelming Chinese demand amid cratering property markets. The resulting weakness in retail sales and confidence is generating deflation.

“With deflationary pressures mounting despite expectations for more aggressive policy easing, the Chinese 10-year yield has dropped below 1.6%, signaling a flight to safety,” says Carlos Casanova, economist at Union Bancaire Privée.

This scenario, Casanova adds, “could mirror Japan’s experience in the early 1990s, with the potential for a significant carry trade — borrowing in yuan to invest in higher-yielding U.S. assets — which could have major implications for US risk assets, particularly if policymakers allow the yuan to weaken in 2025.”

The good news is that data suggest China is regaining some of its footing. Services sector activity among private companies rose to a seven-month high in December. The Caixin services purchasing managers’ index from S&P Global rose to 52.2 from 51.5 in November.

Still, headwinds are intensifying, says Wang Zhe at Caixin Insight Group. The “external environment,” the economist warns, is poised to become “more complex” in 2025, requiring “early” policy strategies and “swift responses.”

On Monday, Beijing regulators convened in a bid to reassure nervous investors selling Shanghai and Shenzhen shares. Officials at both exchanges stressed that China’s US$17 trillion economy is underpinned by “solid fundamentals and resilience.” They also said they’re actively working “to solicit opinions and suggestions” from foreign institutions.

Part of this effort, Casanova observes, is for several major cities to introduce consumption vouchers. Coastal metropolises like Shanghai are focusing on services such as dining and entertainment, while inland cities in Hubei and Sichuan are targeting sectors like furniture, automobiles, and electronics.

It’s promising to see Beijing show “greater willingness to implement additional measures,” he says.

Among them is a move by the PBOC to step up support for innovation. The idea, as the central bank puts it, is to devise ways to encourage “high-quality foreign capital” to invest in China’s battered tech sector.

Above all, though, Pan’s team is pledging to keep the currency stable. The pro-PBOC Financial News publication says China’s monetary authority will “resolutely guard against the risk of exchange rate overshooting and maintain the basic stability” of the yuan.

It notes that past “experience of multiple rounds of appreciation and depreciation” proved Pan has “sufficient” tools to keep the exchange rate “basically stable.”

Only time will tell. Declines in the yuan tend to be closely correlated with downward pressure on China’s stock markets.

Louis Gave, economist at Gavekal Research, points out that the gap between benchmark financing costs in the US and China has widened roughly 80 basis points since early December.

“This reinforces the market narrative of an exceptional — and likely inflationary — US economy on the cusp of another growth phase, while China stares over the precipice of a deflationary lost decade,” Gave says. That is the “message from equity markets, with Chinese stocks having begun the year in a funk.”

Yet, Gave says, a “broader look at asset markets in China and the US tells a different story, as Chinese equities outperformed the apparently all-conquering US stock market in 2024.” Heading into 2025, Gave notes that despite China’s challenges, underlying fundamentals may favor the valuations of Chinese equities.

That depends partly on the PBOC getting more aggressive about stabilizing Asia’s biggest economy.

As of now, says Mohamed El-Erian, chief advisor at Allianz, the “implosion” of yields on Chinese government bonds is fueling “what could become self-fulfilling worries about the Japanification of the economy.” This “yield phenomenon has intensified” in recent days, he adds.

Fred Neumann, chief Asia economist at HSBC, notes that “after many fits and starts over the past year, greater evidence is needed that China’s economy is responding to stabilization measures.”

There are signs that more muscular action is on the way. Last month’s annual Central Economic Work Conference prioritized putting a floor under stock and property markets.

“Policymakers’ ‘pain threshold’ regarding growth and asset prices may have been reached,” write analysts at Goldman Sachs. “But policy delivery is necessary to drive equity gains in 2025.”

There’s not a moment to waste, says Homin Lee, senior macro strategist at Lombard Odier. Because the “underlying momentum for China remains quite fragile,” Lee says, “it will take some efforts from the authorities to change the conversation on the country’s … deflationary dangers” in the medium term.

Of course, there’s ample reason to worry that the dollar’s best days are behind it as investors home in on Washington’s $36 trillion debt load. Team Trump, meanwhile, has hinted at plans to weaken the dollar to gain trade advantage versus China and the rest of Asia. Trump also has threatened to reduce the Fed’s autonomy, giving his White House a direct say in US rate decisions.

Even so, many economists think a reversal in the dollar might take longer than the bears believe.

“The dollar may be vulnerable, but only if the US data confound market expectations that the Fed doesn’t cut rates more than once in the first half of this year, and not by more than 50 basis points in the whole of 2025,” says Kit Juckes, chief FX strategist at Societe Generale.

Though “there’s a good chance of that happening,” Juckes says, “it seems very unlikely that cracks in US growth will appear early in the year – hence my preference for taking any bearish dollar thoughts with me into hibernation until the weather improves.”

Part of the doubt centers on the PBOC. There are a number of reasons why neither Pan nor Xi wants to see the yuan fall sharply.

For one, a weaker yuan would make it harder for highly indebted companies like property developers to make payments on offshore debt, increasing default risks in Asia’s biggest economy. Seeing #ChinaEvergrande or #ChinaVanke trending again in cyberspace is the last thing Xi’s Communist Party wants.

For another, the monetary easing needed to sustain the yuan’s declines could set back Xi’s deleveraging efforts over the last five years. Beijing has made important strides toward reducing China’s financial excesses and improving the quality of the nation’s gross domestic product.

As a result, Xi and Premier Li Qiang have been reluctant to let the PBOC slash rates more assertively, even as deflation clouds China’s outlook.

Increasing the yuan’s use in trade and finance might be Xi’s biggest reform success over the last dozen years. In 2016, China won a place for the yuan in the International Monetary Fund’s “special drawing rights” basket joining the dollar, yen, euro and pound.

Since then, the currency’s use in trade and finance has soared. Excessive easing now might dent trust in the yuan, slowing its progression to reserve-currency status.

A weaker yuan might also trigger a broader Asian currency war that’s in no one’s best interest. Tokyo might go all-in on an even weaker yen, pulling South Korea into the fray.

Memories of 2015 are clearly entering into Beijing’s equation. China’s move to devalue the yuan by nearly 3% a decade ago triggered a destabilizing capital flight that still haunts Communist Party bigwigs. Over the next year, Xi’s team had to draw down Beijing’s foreign exchange reserves by $1 trillion to restore calm.

For now, the “PBOC is signaling that it wants a stable RMB, probably dashing the hopes of those betting that RMB will continue to devalue meaningfully against the US dollar,” says longtime China watcher Bill Bishop, who writes the Sinocism newsletter. 

Robin Brooks, economist at the Brookings Institution, says that “medium-term, this does raise the risk of capital flight out of China, especially if the US imposes tariffs.” Generally speaking, Brooks believes, a falling yuan won’t necessarily shake up the global economy because “the yuan is heavily manipulated and isn’t moving.”

Still, risks abound. A weaker yuan could make China an even more contentious issue in US politics as a seemingly uniquely anti-China administration takes power.

They include hardliners like Peter Navarro, co-author of a book titled “Death by China”, as top trade adviser. The same goes for China critic Marco Rubio as Trump’s secretary of state. Or adding Robert Lighthizer and Jamieson Greer to Trump’s trade negotiation team.

There’s hope that Trump’s pick for Treasury Secretary, Scott Bessent, can ensure that cooler heads prevail. Bessent, it’s believed, would represent the camp in Trump World making sure Trump’s tariff talk is merely a negotiating tactic to achieve a giant trade deal with Beijing.

Either way, Team Xi might want to avoid drawing Trump’s ire. “In our view, these [risks] indicate the PBOC would like to manage the pace of yuan depreciation against the dollar and avoid sharp depreciation before the US tariff announcement,” economists at Goldman argue.

Only Pan and Xi know for sure, though. How Beijing responds to both global and domestic risks in 2025 with its yuan policy will keep Asia markets on edge all year.

Follow William Pesek on X at @WilliamPesek