Real economy will determine currency's value

Markets have become even more divided over the trend of the yuan after it registered major gains early this month in both onshore and offshore trading, with some analysts saying the Chinese currency may rise moderately against the dollar this year. Analysts have also argued that given China's sound economic fundamentals, even if the yuan were to further weaken against the US dollar, the depreciation will not be sharp.

The yuan registered the biggest gain in a year in overnight trading in the offshore market on Jan 5 thanks to the weakening of the dollar and strengthened scrutiny of foreign exchange purchase by China's monetary regulators. The yuan broke the 6.87 mark against the greenback in intraday trading to hit 6.8648 in the offshore market, up by 900 basis points compared with the previous day's lowest level. It also rose strongly in onshore trading later on.

The yuan surged at a time when the markets had expected it to continue weakening after it fell nearly 7 percent in 2016. Analysts said the People's Bank of China, the central bank, sent a series of signals in December hinting that the authorities will strengthen regulation of capital outflow to shore up the yuan, which, coupled with the weakening of the dollar index, is behind the yuan's gains.

At a two-day meeting that concluded on Jan 6, the central bank said it will "further improve the yuan's market-oriented exchange rate formation mechanism, and actively guide and stabilize market expectations to keep the currency basically stable at a reasonable and equilibrium level".

The dollar's pace of appreciation, meanwhile, has slowed and it seems to be entering a cycle of correction. "The dollar has shown signs of weakening after continual rises in recent months," said Jiang Chao, analyst of Haitong Securities. The dollar index, which measures the dollar's value against six major international currencies, tumbled to 101.31 in intraday trading on Jan 6, down from 103.81 registered on Jan 3.

"The continual depreciation of yuan has led to a massive amount of accumulated short positions and once the yuan strengthens, the short sellers would rush to square their positions, pushing up the yuan," Jiang said. "Another cause is the strengthened scrutiny of foreign exchange purchase by the central bank and combating of underground banks."

Analysts such as Ma Jun, chief economist with the central bank, say the markets may have overestimated the prospects of the dollar.

US president-elect Donald Trump has vowed to adopt a pro-active fiscal policy. As a result, markets expect the new US administration to issue new debts; the yields of the US Treasuries, therefore, have surged, which may further push up inflation and the dollar index.

Ma, however, said such expectations might be too optimistic. "The recent sharp dollar appreciation actually has an effect of contraction on US exports," he said in late December, adding that the soaring Treasury yields might have a dampening effect equal to two interest rate hikes on the economy.

The US has accumulated as much as $20 trillion of debt. And if Trump continues to launch massive infrastructure programs, the US' debts will rise further, dampening the chances of the dollar gaining in value.