US dollar oversupply behind renminbi's strength

Ever since June 2021, the renminbi has been performing strongly relative to the US dollar. It has been the first time for the Chinese currency to show such sustained performance against the US dollar since China introduced foreign exchange reforms in August 2015. From June 15, 2021 to Jan 25, the US dollar index gained 5.97 percent while the yuan appreciated by 1.11 percent against the US dollar.

The difference in the 10-year bond yields between China and the United States has been narrowing since mid-2021. In late June, the yield on 10-year US Treasury bonds was 1.5 percent while that on China's corresponding bond was 3.1 percent. The difference came in at 160 basis points. The difference contracted to 92 basis points on Jan 25.

In terms of policy, the People's Bank of China, the country's central bank, raised financial institutions' foreign exchange reserve requirement ratio from 5 percent to 7 percent on June 15. The ratio was further elevated by 2 percentage points on Dec 15. The two moves, aimed at contracting liquidity in the foreign exchange market, did not hold up the renminbi's appreciation completely.

There is only one direct reason for the bullish renminbi－rising global demand for the renminbi amid an oversupply of US dollars. The differences in liquidity, supply and demand between the two currencies have resulted in the yuan's recent strong performance, which does not match the interest rate parity theory.

Data from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) showed that the Chinese currency accounted for 2.7 percent of global payments by value in December, overtaking the Japanese yen and seizing fourth place globally. According to Currency Composition of Official Foreign Reserve (COFER) under the International Monetary Fund, the renminbi took up 2.66 percent of foreign exchange reserves globally by the end of the third quarter of 2021, compared to 2.16 percent a year earlier.

Ever since COVID-19 hit the world in early 2020, the renminbi has gained an increasing proportion of global foreign exchange reserves. Data from COFER showed that global foreign exchange reserves grew by $899.7 billion from the end of 2019 to September-end 2021, of which renminbi made up 11.62 percent. This helped the renminbi rank third in terms of increased foreign exchange reserves globally during the monitoring period, behind the US dollar and the euro.

In addition, the framework under which US monetary policy will transform has also supported the renminbi's upward momentum. The US Federal Reserve's total assets were $4.24 trillion on March 5, 2020 and then $8.87 trillion on Jan 20, up 109.2 percent. Most of the expansion was realized by asset purchases. As a result, the supply of US dollars increased significantly in the international financial market over the past two years.

Ever since the subprime mortgage crisis in 2008, the Fed has introduced more liquidity tools and conducted large-scale asset purchases (LSAP) to improve the financial market and stimulate the economy. In early 2009, the reserve requirement exceeded $800 billion, while the number was only $10 billion before the crisis.

Liquidity has been sufficient in the US financial market. From mid-August to the end of last year, the Federal Reserve Bank of New York kept its overnight reserve repurchase scale at around $1.1 trillion to $1.9 trillion. The size has been kept between $1.5 trillion and $1.7 trillion so far this year.

In addition, China's advantages in manufacturing have been translated into large trade surpluses for the country, which also helped pillar the bullish performance of the Chinese yuan. According to the General Administration of Customs, China reported a trade surplus of over $676.4 billion last year. Specifically, the trade surplus of general trade hit $372.9 billion, accounting for 55.1 percent of the total trade surplus. The ratio was 44.4 percent in 2019.

China's manufacturing sector exports were hit the most by COVID-19 in February 2020, according to the administration, which explains the extremely high comparative readings in February 2021. But manufacturing exports went back on a "normal" track in June 2020 and 10 percent year-on-year growth was reported in August 2020. In this sense, the increase realized since August 2021 is even more noticeable given the higher base data.

These numbers show that the growth of China's export industrial chain is closely related to the development of domestic production capability. Ever since the mid-1990s, exports in manufacturing have been a major driver in China's trade surplus. The country's strong production and export capabilities have been increasingly evident since the pandemic.

In general, China's manufacturing industry achieved growth both in quality and quantity in 2021. The total value of investment in manufacturing increased 13.5 percent year-on-year in 2021, which was much higher than the 4.9 percent growth rate of fixed asset investment all over the country last year. The stronger performance of manufacturing－especially in the second half of 2021－has thus become a key pillar of the stronger renminbi.

On top of that, China's ongoing opening-up is another important reason for a stronger renminbi. According to the Ministry of Commerce, China attracted $173.5 billion in foreign direct investment in 2021, up 20.2 percent year-on-year. Compared to the data in 2019, the average growth rate from 2020 to 2021 was 12.1 percent, or 6.4 percentage points higher than the global average.

China's financial assets have been increasingly appealing, supporting a stronger yuan. A more extensive financial opening-up has ushered in more international investors. Chinese financial assets have been included in more international investment portfolios.

The Chinese bond market has been included in all of the three major international bond indexes. Data from market tracker Wind Info showed that bonds in China's interbank market held by overseas institutions reached 3.66 trillion yuan ($579.6 billion) in December. By Jan 25, overseas investors owned 3.73 percent of the total A-share free-float market cap, which was higher than the 3.23 percent in 2019.

Last but not least, China's manufacturing industry has played the role of "a safe haven" for the global manufacturing sector amid the pandemic. This has also helped push up the renminbi's value. China was the only economy to report a positive increase in 2020 and the country's GDP growth rate came in at 8.1 percent last year. The global supply chain difficulties brought by the pandemic have also affected China's economic growth. But thanks to China's increasing competency in general trade and precise policy adjustments regarding commodity prices and energy issues, the negative impact of the global supply chain disruptions on the economy has been mitigated to some extent.

The writer is a research fellow at the National Academy of Development and Strategy at Renmin University of China, and vice-dean of the School of Economics at Renmin University of China. The author contributed this article to China Macroeconomy Forum, a think tank.

The views don't necessarily reflect those of China Daily.