The Chinese yuan – or renminbi – has risen sharply in recent weeks, and the Central Bank of China has pegged the currency at 6.19 to the dollar, the highest level in 19 years. The authorities of the world’s second-biggest economy allow the yuan to trade by one percentage point in both directions against the greenback and economists and others continue to speculate when, or whether, the currency will freely float. Brian Jackson, global foreign exchange strategist at Coutts, looks at the prospects for further yuan gains. As ever, the views expressed in this article are those of the author and not necessarily shared by this publication.

The Chinese yuan has risen sharply in recent weeks, prompting officials to take steps to limit speculative activity. We nevertheless believe the case for further yuan appreciation remains intact - though officials are likely to try to moderate the pace.

Although domestic economic data have been mixed, yuan sentiment has been buoyed by signs that Beijing is seeking to boost the flexibility and international use of the currency. The yuan is a tightly-controlled currency and Chinese authorities limit daily moves in its exchange rate versus the US dollar to no more than 1 per cent. Officials, however, have hinted that this range may be widened in coming months, providing greater scope for appreciation.

Providing further support to the currency was news that the Hong Kong authorities are relaxing local rules relating to yuan capital flows. And in mid April, the Reserve Bank of Australia announced plans to allocate around 5 per cent of its foreign reserves to yuan-denominated assets, representing a significant vote of confidence in the yuan as a potential reserve currency.

These developments have clearly provided much of the impetus for the gains posted by the yuan in recent weeks. However, this acceleration is likely to have been regarded with some caution by Chinese policymakers, who have shown in recent years a preference for exchange rate reform to progress at a gradual and steady pace. Officials have also been keen to avoid giving the impression that yuan appreciation is a “one-way bet” - a suggestion that would encourage speculative activity and attract “hot money” inflows into Chinese financial markets, providing further impetus to yuan gains.

The prospect of quick yuan appreciation can also distort incentives for Chinese banks and companies. Recent data showing a sharp pick-up of foreign currency lending in the Chinese banking system suggests that banks are lending and firms are borrowing foreign currency based on expectations that a stronger yuan will yield them a quick profit, rather than for business-related uses, such as to fund foreign investments or provide trade finance.

This type of activity is always frowned upon by Chinese authorities. Over the weekend, the State Administration of Foreign Exchange, the agency responsible for regulating the Chinese foreign exchange market, announced that it would tighten rules to limit the size of banks’ foreign currency loans relative to the size of their foreign currency deposits.

Some estimates have the foreign currency loans-to-deposits ratio in the Chinese banking system as high as 170 per cent. However, SAFE is tightening scrutiny and enforcement, with the aim of bringing this figure down to 75 per cent for Chinese banks and 100 per cent for foreign banks. Officials will also be doing more to make sure that companies’ demand for foreign currency is based on trade flows and business-related purposes rather than driven by speculation on yuan appreciation.

Full convertibility

Although SAFE’s announcement over the weekend prompted some yuan weakness early this week, we do not consider this a sign that the trend of yuan appreciation is set to reverse. Longer-term policy objectives by Chinese officials - including the need to boost domestic consumption and reduce China’s dependence on external demand as a source of economic growth - continue to point towards the need for a stronger currency in coming years.

Beijing is also proceeding with its plans to enhance the status of the yuan as an international currency. Efforts are aimed at increasing its use in global trade and investment flows and taking the necessary steps for other countries to accept the yuan as part of their foreign reserves. An important requirement to achieve this objective is to make the yuan fully convertible. Earlier this week (coinciding with the efforts designed to curb speculative activity), the top decision-making body of the Chinese government, the State Council, announced that it had instructed officials to draw up plans to make the yuan fully convertible in the capital account.

This suggests that portfolio investment and borrowing will be liberalised significantly in the next few years, with fewer restrictions on foreigners investing in Chinese markets and Chinese residents investing in foreign markets.

Gradual pace

These longer-term objectives of Chinese authorities suggest the case for further yuan appreciation remains intact – in line with our forecast for the dollar/yuan exchange rate to trend lower over the next 12 months.

Although the recent acceleration in yuan appreciation has taken this currency pair beyond our near-term forecasts, the events of the last few days highlight the risk that there could be some near-term interruptions to the longer-term trend as officials try to prevent yuan gains from happening at too fast a pace. Nevertheless, we continue to forecast dollar/yuan to fall in coming months, with risks increasingly skewed to the downside for our forecast of 6.10 at the end of the first quarter of 2014.