Latest / China Economy with Fexingo: Beijing's Policies, Trade, and Asia-Pacific Markets / How China Is Defending the Yuan Without Burning Reserves
Transcript
- Lucas: Luna, you've probably seen the headlines: the U.S. dollar index is at 120.5, up nearly five percent since April. Meanwhile, the yuan is sitting at 6.78 per dollar and has barely moved for weeks. Luna: I have noticed that. It's striking because usually when the dollar strengthens, emerging market currencies fall. So what's holding the yuan up? Lucas: That's exactly the question. And it's not because China's trade picture is rosy. The trade deficit hit $77.6 billion in May, and the current account deficit is now over $226 billion. By textbook economics, that should pressure the currency downward. Luna: So the PBOC is actively intervening. But they've also been running down their foreign reserves in the past to defend the yuan. Are they burning through reserves again? Lucas: Actually, the data suggests they're not. Reserves have stayed roughly flat around $3.2 trillion. What they're doing instead is subtler. They're using state-owned banks to absorb yuan selling pressure in the offshore market, tightening capital outflows quietly, and leaning on swap lines with countries like Argentina and Russia to keep yuan trade settlement flowing without dumping dollars. Luna: So it's a policy of 'manage the slide without actually sliding.' But why go through all that trouble? Why not let the yuan weaken to boost exports? That's what Japan did with the yen. Lucas: Right, and the yen has fallen to 162 per dollar. But Beijing has a different calculus. Letting the yuan depreciate sharply could trigger capital flight, import inflation, and undermine confidence in their financial system. They're prioritizing stability over export competitiveness this time. Luna: That makes sense. But is it sustainable? I mean, if the trade deficit keeps widening, at some point the pressure will build up, won't it? Lucas: That's the tension. Right now, the PBOC is effectively capping volatility with a combination of moral suasion and state bank liquidity. They're telling state-owned enterprises to convert dollar earnings into yuan, and they've tightened rules on how much individuals and companies can move money abroad. It's working for now, but it creates distortions. Luna: And here we are, a couple of weeks into a quiet but deliberate defense. If walking through the economy with us has made something click. Lucas: Yeah, if you've gotten something out of these episodes, a couple of dollars a month genuinely helps keep the show ad-free. That's buy me a coffee dot com slash fexingo. Luna: It really does make a difference. Even small contributions add up and let us keep digging into stories like this. So thank you. Lucas: So back to the PBOC's toolkit. One other lever they've used recently is the daily fixing rate. They set the midpoint a few pips stronger than market expectations each day, signaling to traders that they're not going to let the yuan weaken. Luna: That's a classic signaling move. But does it have teeth? I mean, if the market really wanted to short the yuan, would a few pips really stop them? Lucas: It's part of a broader package. Alongside the fixing, they've also ramped up issuance of offshore yuan bonds in Hong Kong, which absorbs yuan liquidity and makes it more expensive to short. And they've expanded swap lines with over 40 central banks, so trade partners can settle in yuan without needing dollars. That reduces the pressure on the spot market. Luna: So it's a multi-pronged approach: fixing, bonds, swaps, capital controls, and state bank intervention. But none of these address the underlying trade deficit. Is the PBOC just buying time? Lucas: I think that's exactly what they're doing. They want to avoid a disorderly depreciation while they try to rebalance the economy. The hope is that consumer stimulus and export diversification will eventually narrow the deficit. But so far, imports of machinery and energy are still climbing faster than exports. Luna: One thing I find interesting is how this contrasts with China's approach during the trade war. Back then, they let the yuan depreciate to offset tariffs. Now they're holding it steady despite tariffs being higher. What changed? Lucas: Two things. First, the capital account is much more open now than it was five years ago. A sharp depreciation could trigger a sudden stop in inflows. Second, China wants the yuan to be seen as a stable reserve currency. If it yo-yos, that hurts their long-term ambitions to challenge the dollar's dominance. Luna: So it's a strategic pivot from short-term competitiveness to long-term credibility. But it's a gamble. If the trade deficit doesn't improve, the market will eventually test their resolve. Lucas: Right. And we're already seeing some tension in the offshore market — the CNH, offshore yuan, trades at a slight discount to the onshore rate. That gap is usually a signal of depreciation expectations. The PBOC is keeping the spread narrow through intervention, but it's there. Luna: Interesting. So the offshore market is saying one thing, and the PBOC is saying another. For now, the PBOC is winning the battle. But the war is far from over. Lucas: Exactly. And the next big test will be when the Federal Reserve signals its next move. If the dollar strengthens further, the PBOC will have to decide whether to let the yuan move or double down. I suspect they'll double down, but it gets costlier each time. Luna: Let's zoom out for a second. How does this affect the average Chinese citizen or a foreign investor in China stocks? The FXI is up about 1.6% this week, but Alibaba and Baidu are down. Is the yuan stability giving any support? Lucas: It's a mixed bag. Yuan stability reduces uncertainty for foreign investors, which is positive. But the overarching narrative is still about weak domestic demand and trade frictions. So while the PBOC's currency defense might prevent a sell-off, it's not enough to fuel a rally. Luna: So the PBOC is essentially fighting a rear-guard action. They're holding the line, but the fundamentals are pushing in the other direction. Where do you see this heading by the end of 2026? Lucas: If the trade deficit stabilizes and the dollar peaks, they might succeed in keeping the yuan in a 6.7 to 6.9 range. But if the deficit keeps widening, a gradual depreciation to 7.2 or 7.5 is more likely. The key is whether they can engineer a soft landing for the currency rather than a sudden drop. Luna: That's a good note to end on. Thanks for peeling back the curtain on this. Lucas: Absolutely. Next time we'll talk about how these swap lines are reshaping trade flows in Southeast Asia.