The Chinese yuan surged to a 16-month high, but Beijing may not be happy about it

• China's stimulus package has boosted market sentiment and pushed the Chinese yuan to a 16-month high.
• The People's Bank of China cut interest rates and reduced bank reserve requirements.

China's massive stimulus package for its battered economy has boosted market sentiment and injected confidence into the Chinese yuan.

On Tuesday, China's top regulators appeared at a press conference together in an effort to boost market sentiment. At the briefing, People's Bank of China, or POBC, governor Pan Gongsheng announced cuts to several interest rates and a reduction in the amount of money banks need to hold in reserve.

"The PBOC unleashed policy euphoria as markets deemed the 'big guns' unleashed with the rash of aggressive stimulus," Vishnu Varathan, Mizuho's macro research head for Asia excluding Japan, wrote in a note on Wednesday.

This not only boosted China's previously downbeat stock markets, but also helped the yuan pull off a "remarkable surge," Varathan added.

On Wednesday, the US dollar to offshore Chinese yuan, or CNH rate fell to as low as 6.9951, the first time it breached the 7 per dollar level since May 2023. This means $1 could buy fewer Chinese yuan.

The USD/CNH is about 1.6% lower so far this year. The currency pair was now around the 7.01 level at 12 p.m. in China Standard Time.

To be sure, the yuan has been strengthening recently, and this trend is not all thanks to China.

The US Federal Reserve announced a big interest rate cut last week. This is putting pressure on the US dollar, because rate cuts mean yields in dollar assets would be falling.

In anticipation of the Fed rate cut, the yuan has been strengthening against the dollar since end-June, in part because some Chinese exporters have been repatriating dollar earnings they were hoarding.

In August, capital inflows into China reached $7 billion — the first inflow since July 2023, according to an analysis from Larry Hu, the head of China economics at Macquarie Group.

Exporters also converted $37 billion of foreign exchange into the yuan — the highest level since September 2022, Hu added.

A strong yuan is bad for exports

Even though a strong yuan signals confidence in China's economy, analysts aren't sure the gains will hold.

That's because a stronger yuan would make China's exports more expensive and less competitive.

Given that China's consumer confidence is really weak and domestic demand is flagging, while exports — a key pillar of the country's economy — have been robust, Beijing may not be happy keeping the yuan stronger for longer.

As Swiss private bank Lombard Odier's CIO office wrote on Tuesday, there is a "fundamental inconsistency" between a strong yuan and credible reflation, which refers to policies intended to reverse deflation — an economic challenge China is facing now.

China has a tight grip on the yuan, so Beijing does have a big influence on the currency.

On Tuesday, Pan said China will prevent the markets from forming one-sided expectations and guard against the risk of the yuan overshooting so that the currency's exchange rate can be at a "reasonable and balanced level."

On Wednesday, China's central bank indicated its neutral stance on the yuan via way of its daily midpoint fix, which it pegged at 7.0202 per dollar — this is against the 7.0206 traders and analysts had estimated in a Bloomberg survey. The yuan is allowed to trade within a 2% range above or below the midpoint.

Macquarie's Hu wrote in his note on Friday that there may limited room for the yuan to gain further.

"While the falling US yield may encourage exporters to convert more dollars into RMB, the main determinant of exporters' FX conversion is China's domestic demand and business confidence, which remain weak," wrote Hu, referring to the renminbi, the official name for the Chinese currency.

"The PBOC may not want to see a rapid CNY appreciation that hurts exports, the main bright spot for now," he added.