Will U.S. interest rate hikes sink the yuan, lure foreign capital out of China and slow already-decelerating growth to a crawl — deepening Chinese stocks’ swoon? With the U.S. Federal Reserve talking up tighter policy, that fear is reemerging. But don’t worry. Fed hikes don’t guarantee the yuan will tumble. Even if the yuan does fall, history shows that alone won’t suck capital out of Chinese markets and doom stocks. Let me explain.
Last March, I told you fears of a strengthening yuan slamming China’s economy were bunk. That proved true. After jumping 6.5% versus the dollar in 2020, the yuan rose another 2.6% last year. But the export slump many feared never came. Just the opposite occurred — exports skyrocketed 29.9%, helping boost GDP by 8.1%. Yes, year-on-year GDP growth slowed as 2021 progressed — but not because of currencies. The slowdown is heavily influenced by math: the sharp economic rebound in second-half of 2020 simply means year-on-year comparisons start from a much higher base. Beyond this, domestic efforts to rein in property market credit and Covid were headwinds, but relatively small ones. The bear market? Currencies didn’t cause it, either. Sentiment sparked the selloff — a fretful overreaction to real estate debt troubles and regulatory overhauls.
Now strong yuan fears have flipped: Many foresee Fed rate hikes propelling the dollar higher against it — causing foreign investors to spurn China while inflating Chinese firms’ dollar-denominated debt servicing costs. They argue today is doubly dangerous since 2022 Fed hikes would follow the People’s Bank of China’s (PBOC) recent loan prime rate cut. The divergence, they say, threatens to supercharge yuan weakness. Now, there is some truth here. If everything else were equal, currencies chase higher yields, so rates rising in the U.S. and falling in China should lead capital to flow to the U.S. Hence, your government is watching.
But all other things are never equal — a point often forgotten. Anytime the Fed starts talking up rate hikes, loads of analysts see ghosts of past problems — like 1997-98’s Asian financial crisis. Back then, U.S. hikes sparked currency woes for several of China’s neighbors. Those countries, like Thailand, learned the hard way about what economists call the “impossible trinity” — the combination of a fixed foreign exchange rate, free capital movement and independent monetary policy. Theory holds that a country can have two of those three but not all three — at least not in their extreme forms. During the crisis, Thailand and other countries’ dollar pegs came under pressure — and eventually collapsed, sparking a regional meltdown reverberating worldwide.
This may have you worried about China today. Don’t be. The government’s gradual currency reforms over the past decade and a half make a 1997-98-style crisis unlikely. Yes, China is pursuing each of the impossible trinity’s components — but not in an extreme fashion. Its 2015 reforms allowed the yuan to float in a wider band — and several shifts to its currency index basket have reduced dollar dependence. It also manages capital flows, suggesting there won’t be a huge mainland exodus.
Moreover, history shows rate hikes alone don’t drive currency movements. Since the PBOC loosened its dollar peg in 2005, only one full Fed rate-hike cycle has occurred, starting on Dec. 16, 2015. The yuan fell 6.9% versus the dollar over the next year and Chinese stocks — already falling in the wake of the speculative bubble’s bursting — kept sliding for two months after the hike. But neither trend lasted. One year after the U.S. hikes began, the MSCI China was up 8.7% — not huge, but still positive. Two years after the hikes started, Chinese stocks had soared 55.1% and the yuan was back within 2% of its pre-hike level versus the dollar.
A broader look at other currencies confirms Fed hikes’ lack of power. Since good data comparing the dollar to a basket of global currencies began in 1973, nine Fed hike cycles have occurred. The dollar averaged a 0.4% decline in the 12 months after those cycles’ initial hike, rising five times and falling four. Twenty-four months later, it averaged a 0.002% rise — meager and meaningless! It fell twice as often as it rose.
Why didn’t rate hikes translate to dollar gains? Because currency markets, like all efficient markets, pre-price central bank moves. Just look at today. The Fed has yet to raise rates, but forecasters have projected 2022 rate hikes for months. Investors already factor this into decisions across every sufficiently liquid market — stocks, bonds, currencies and beyond — simultaneously.
Then, too, markets are never univariate. China remains a key world growth engine, with exceptional companies in growing industries — particularly in the tech arena. The pandemic showed the country’s critical role in global supply chains. Will investors dramatically reduce exposure to those benefits if the yuan falls a bit against the buck? No!
Even if they do, it doesn’t doom China’s economy or market. For one thing, dollar-denominated debt is only about 6% of overall Chinese debt — not nearly big enough to wreak havoc on your broader economy. China also has amassed huge reserves of dollars through trade, insulating the country against dollar moves. Don’t take my word for it. Look to markets. Dollar-denominated Chinese government bonds pay almost no premium over U.S. Treasurys. Investors would demand more yield if this risk were real.
Currency zigs and zags don’t dictate stocks’ direction either. For example, since late May 2020, the yuan has surged 12.4% against the dollar. Conventional wisdom says Chinese stocks should be strong. Yet they are down 5.5% over that stretch. Other factors — namely sentiment surrounding real estate debt and regulatory overhauls — are driving returns. Overall since the PBOC loosened its dollar peg in July 2005, Chinese stocks rose in 4 of 6 calendar years the yuan fell against the dollar. That compares to 7 rises in the 10 years it advanced against the greenback. Not much difference.
See today’s weak yuan worries for what they are: a sentiment indicator. Consider: Those who worried early 2021’s strengthening yuan would sink China’s economy should cheer a potentially weaker yuan. They aren’t. Why? Because when fears are high, worriers seek more worries. Currencies are an easy bogeyman to conjure — always “too strong” or “too weak” but never “just right.” But neither logic nor history support such fears. See past them, and remember: False fears are bullish, always and everywhere.
Fed hike anxiety may seem to highlight a new headwind prolonging China’s bear market. But it is just the opposite: a sign sinking sentiment is setting up the positive surprises that drive markets higher. Don’t let Fed fretting keep you from capturing Chinese stocks’ rebound.
Ken Fisher is the founder and executive chairman of Fisher Investments.
The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.
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