Lunar New Year: China's reopening lifts the yuan

The yuan had a good Lunar New Year. Having flirted with 7.35 to the dollar in late October, the onshore and offshore rates rallied back toward 6.78, one of the fastest percentage recoveries on record. Beijing did the work by abruptly scrapping its zero-Covid rules, and foreign money poured into beaten-down Chinese shares and government bonds. Treating the rally as a one-way bet on Chinese economic strength, though, overlooks what will happen to the capital account once China's borders reopen.

How the yuan fell so far

Last year's slide owed as much to Washington as to Beijing. The Federal Reserve lifted its policy rate from near zero in March to a range of 4.25 to 4.5 per cent by December, while the People's Bank of China was trimming rates to support a slowing economy. American ten-year yields rose above Chinese ones in April for the first time since 2010, and exporters and carry traders alike preferred to sit in dollars. Lockdowns in Shanghai in the spring, and rolling closures elsewhere through the autumn, added a growth scare on top.

Then policy turned on both sides of the exchange rate. In early December the authorities dismantled most testing and quarantine rules, and on 8 January China stopped quarantining arrivals and reopened its borders. At the same time the dollar was weakening broadly as markets began to price an end to Fed tightening. The yuan's rebound therefore rests partly on a softer dollar that China does not control.

Dollar hoards come home

The first leg of the rally came from hedges and corporate dollar hoards being unwound. Chinese exporters built up hundreds of billions in dollar deposits during the trade boom of 2021–2022, and many of them rushed to convert that money into yuan before the holiday.

Some of this is seasonal. Firms need local currency before the holiday to pay wages and year-end bonuses, so conversions tend to cluster in January whatever the exchange rate. This year the motive was sharper, because an exporter that had held dollars while the yuan fell had been rewarded, and once the trend reversed each week of delay cost money. That makes the move self-reinforcing on the way up, but it also gives it a natural end: once the backlog of deposits has been converted, this source of demand for yuan dries up.

Money in, tourists out

At the same time, global funds rotated out of crowded Western stocks and into Chinese internet and consumer companies. To buy them, they needed yuan, and plenty of it.

Much of that buying ran through Hong Kong and the Stock Connect link into mainland shares, which drew heavy northbound inflows in January. Portfolio money of this kind moves quickly in both directions. It arrived because Chinese equities were cheap after a brutal 2022 and because reopening offered a growth story while America and Europe fretted about recession. Once the easy re-rating is done, further inflows will depend on corporate earnings, which will take several quarters to show whether the optimism was justified.

That inflow will soon meet traffic heading the other way. Open borders mean Chinese tourists start travelling abroad again, and outbound tourism has historically drained $250 billion a year from China's services account.

The recovery in travel will not be instant. International flight capacity is still far below its pre-pandemic level, many passports lapsed during three years of closure, and foreign airlines and hotels are still rebuilding routes and staff. But demand has been bottled up since early 2020, and the drain will grow through the year as capacity returns. Every renminbi spent in Tokyo, Bangkok or Paris must first be sold for foreign currency, which is a direct offset to the portfolio money now arriving.

Wealth heads for the exit

Wealthy families and companies, rattled by years of regulatory crackdowns and a slump in the property sector, are also keen to use foreign trips as a chance to move money offshore.

China's capital controls cap individual purchases of foreign currency at $50,000 a year, but the rules have always leaked. Card spending abroad, insurance policies bought in Hong Kong, overinvoiced trade and deposits on foreign property are familiar routes, and most of them work far better when people can travel. The motive to use them has grown since the halt of Ant Group's listing in late 2020, the default of Evergrande and the arbitrary lockdowns of last year, each of which gave savers a reason to keep some wealth beyond Beijing's reach.

What 2015 taught Beijing

The last time these channels ran at full speed, they overwhelmed the central bank. After the surprise devaluation of August 2015, private outflows accelerated and China's foreign-exchange reserves fell from close to $4 trillion in mid-2014 to about $3 trillion by early 2017. The authorities tightened controls hard and spent heavily to steady the currency. That memory makes the People's Bank of China wary of a yuan that swings too far either way, and it is likely to use its daily fixing to lean against an overshoot in either direction.

The bull case, and its limits

The optimists have a real argument. A reopened China should grow faster than last year's official 3 per cent, one of its weakest results in decades, and a recovering economy tends to pull in both direct investment and portfolio money. If the Fed stops raising rates soon, the interest-rate gap that drove the yuan down will narrow. Those forces could lift the currency further for a while, especially if factories running at full tilt keep the trade surplus large.

Much of that good news, though, is already in a move from 7.35 to 6.78. Western demand for Chinese goods is softening as higher rates bite, and export orders were weakening before the holiday. The currency now needs the surplus to hold up just as tourism and private outflows start to chip away at it.

Where the ceiling sits

Between a wider services deficit and steady private leakage, the merchandise trade surplus that propped up the currency through the pandemic will be worn down. The holiday rally is a first, enthusiastic re-rating of Chinese assets. Once outbound travel and private outflows pick up again, probably within months, they are likely to put a ceiling on how far the yuan can climb. By the summer the likelier path is a yuan drifting sideways or softer against the dollar, and the foreign funds that bought at the peak of the reopening trade will be the ones paying for it.