The writer is chief economist at Bank of Singapore
The renminbi has become a prime indicator of the dollar’s fortunes in the same way that Japan’s yen was in the 1990s. Indeed, the sharp rebound in China’s currency this year is a clear sign the greenback is likely to weaken further against the euro and other major currencies.
The renminbi’s increasing prominence marks a significant change for investors. For decades, China’s currency was fixed or very tightly managed by the People’s Bank of China. The renminbi therefore played only a minor part in global markets.
Before the turn of the century, the performance of Japan’s currency was an important indicator of future moves in the dollar. The strength of the yen in the aftermath of the Plaza Accord — when the finance ministers of France, Germany, Japan, the UK and US agreed in 1985 to undertake joint action to weaken the greenback — revealed the currency’s significance to foreign exchange traders. By the 1990s, turning points in the yen often marked changes in the greenback’s direction against the Deutsche Mark, pound and Swiss franc.
The outsized role of Japan’s currency was due to the country’s record trade surplus with the US. The external imbalance between the two economies was the reason changes in the yen’s rate against the dollar came to frequently foreshadow shifts in the greenback’s value against the other major currencies.
If the yen was rising against the dollar, then the currency’s strength implied America’s record trade deficit with Japan was not being funded at the exchange rate prevailing at the time. The foreign exchange market then indicated that capital flows into the US economy were insufficient to offset America’s imbalance in goods and services with Japan. This shortfall caused the greenback to weaken, making US assets more attractive for foreign investors. When capital inflows had increased enough to match America’s trade deficit with Japan, the dollar would settle at the new lower exchange rate against the yen.
Similarly, if the yen was falling against the dollar, then currency markets were signalling that capital flows into the US economy were more than sufficient to fund America’s trade imbalance with Japan at the then prevailing exchange rate. The greenback would appreciate, making US assets more expensive. Then foreign investors reduced their purchases and the dollar settled at a higher rate against the yen.
Changes in the yen’s value against the dollar stood out in the 1990s because Japan was running the largest trade surplus in the world with America. When the yen appreciated, it was also a signal that the US economy was unlikely to attract sufficient capital inflows to fund its overall trade deficit with the rest of the world either. Thus, yen strength against the dollar indicated the greenback was also likely to fall against the Deutsche Mark, pound and Swiss franc.
The yen’s valuable role in predicting subsequent moves in the dollar against other major currencies waned in the 2000s as China overtook Japan to have the highest trade surplus with America. The renminbi, however, was fixed by the PBoC at the same rate against the dollar until 2005 and afterwards closely managed until 2015.
The currency was therefore constrained as an indicator of whether the US economy was attracting sufficient inflows of capital to fund America’s record trade deficit with China, let alone as a predictor of whether the dollar was likely to rise or fall more broadly against other major currencies such as the euro.
Now that the PBoC has allowed to the renminbi to float more freely, it is enabling the currency to assume the yen’s historic role as an important pointer toward future moves in the dollar.
The renminbi’s decline versus the dollar in 2015-16, after the central bank let the currency trade more flexibly, and again in 2018-19 during the US-China trade war foreshadowed the strength of the greenback against the euro. Conversely, the renminbi’s resurgence in 2017 was a leading indicator of the euro’s appreciation against the dollar.
This year the renminbi has rebounded sharply as China’s economy has emerged from the pandemic. The currency’s strength warns more dollar weakness is likely against the euro, pound, Swiss franc and now the yen too.