It has been an interesting year in global currency markets. Early in the year, the U.S. dollars spiked, as the combination of the pandemic and fears of discord within the European Union triggered a trade to “safe haven” assets. However, since May, following a friendly resolution of tensions in the EU, the euro rallied strongly, taking with it the DXY index, which is the market bell-whether for the relative value of the USD. The significant weakening of the dollar against the euro, and to a lesser degree against the Japanese yen, has raised hopes for international investors that the strong-dollar cycle started in 2011 may have ended, which would be supportive of better performance for non-U.S. assets. The chart below shows the DXY’s evolution for the past twenty years: a sharp downcycle for the dollar from 2001 to 2011, followed by a persistent dollar upcycle from 2011 to this year until the recent sharp correction.
Unfortunately for EM investors, when looked at on a broader basis the USD is not as weak as it is against the euro-heavy DXY index. For example, on a trade-weighted basis, as shown below, the dollar has strengthened by 2.1% since the beginning of the year.
In the case of a currency index based on the country component weights in the MSCI EM equity index, the USD has appreciated by 4.2% this year. The yuan has appreciated by about 1% against the USD over this period, while the rest of EM has experienced currency losses of 6.2%.The evolution of the MSCI EM currency index is shown in the chart below from Yardeni.com. We can see that EM as a whole still appears to be in a downtrend relative to the dollar, and both the EMEA and Latin American regions have currencies which are persistently weak relative to the USD.
So, the important question is why is the yuan strengthening at this time and is its rise sustainable? This is what matters to EM investors as China is now 42% of the MSCI index. The answer is in the two charts below. The first chart shows the yuan on the left side and the interest rate differential between China and the U.S. for 2-year government notes on the right side. In a world of negative real rates in both developed and emerging markets, China now has real rates and a growing differential in its favor. The second chart shows China’s trade surplus back at record levels (at a time when both tourism and capital outflows have come down sharply).
It is logical that a combination of high rates and strengthening trade and current accounts would lead to currency yuan strengthening. Given trade tensions with the U.S. (and the rest of the world) and a clear commitment to boosting consumption and moving up the manufacturing value-added chain, it is likely in Beijing’s interest to let the yuan move higher.