U.S. interest rate hike to pile pressure on yuan

Rate hike hits Chinese bonds, exacerbates outflows of capital

While U.S. President-elect Donald Trump continues to blame China for deliberately devaluing its currency to gain trade advantages, a persistently strengthening U.S. dollar is actually responsible for the recent depreciation of the yuan, and that trend is likely to continue after a fresh interest rate hike in the U.S., experts said.

Demonstrating growing optimism about the U.S. economy, the U.S. Federal Reserve raised the federal funds target rate by 0.25 percentage point to between 0.50 and 0.75 percent on Wednesday, the first rate hike of the year and only the second in a decade. The Fed also indicated it would conduct more rate hikes in 2017 than previously expected.

Besides the yuan, the Fed's rate hike will have a broader impact on the Chinese economy, increasing risks for market instability and exacerbating capital outflows, experts said.

Chinese mainland stocks had a mild reaction on Thursday to the Fed's decision, with the Shanghai Composite Index down 0.73 percent at market closing and the Shenzhen Component Index up 0.23 percent.

But the reaction from the Chinese bond market was more dramatic. On Thursday, trading of both 5-year and 10-year sovereign yields came to an abrupt halt, after touching the levels of 1.2 percent and 2 percent, respectively, the first such halt on record.

The Chinese bond market tends to be more closely aligned with the developments in the U.S. because of similar monetary polices adopted by the two countries, but that might have changed now because their policies are diverging, and Chinese bond yields will depend more on domestic economic conditions, Liu Dongliang, an economist at China Merchants Bank, wrote in a note sent to the Global Times on Thursday.

Further devaluation

But more worrisome is the exchange rate of the yuan against the U.S. dollar, because with the domestic fundamentals remaining unchanged, the yuan's exchange rate will be more dependent on the dollar's movement, Liu wrote.

On Thursday, the People's Bank of China (PBC), the central bank, set the yuan's midpoint at 6.9289, 261 points lower than the previous day and the lowest point in more than eight years.

"Here comes the climax of the dollar shock," Chen Shi, head of International Research at Industrial and Commercial Bank of China, wrote in a note sent to the Global Times on Thursday.

The Fed's willingness to adopt a more aggressive monetary policy will put pressure on emerging economies and their currencies, especially China, where the yuan might face further depreciation pressure, Chen said.

The yuan depreciated by 1.69 percent against the dollar in November, with the U.S. Dollar Index hitting a 14-year high of 102.05 at one point in the month, according to PBC data released in December. But the yuan's decline was "relatively small" compared with other major currencies, the PBC added.

It was almost certainly the dollar's appreciation that pushed down the yuan's exchange rate, not domestic economic conditions or government policy, Chen said. And with the new rate hike, this dynamic will continue.

"With the U.S. Dollar Index set to rise, expectations of the yuan's further devaluation will also increase," Chen wrote in the note. If the dollar sees a "moderate appreciation" in the near term, the yuan's exchange rate could bottom out between 7.10 and 7.15 per dollar, Liu said.

While the most direct impact of the U.S. rate hike on China is the depreciation pressure on the yuan, the move could also exacerbate capital outflows from China, as more investors will turn to dollar-denominated assets, which could pose a problem for the domestic economy, analysts noted.

Liu estimated in an earlier note that if the PBC doesn't intervene and assuming the yuan falls to 7.07-7.15 per dollar, China's foreign exchange reserves could witness a drop of $160 billion.