The offshore Chinese yuan (CNY) exchange rate against the US dollar plummeted on August 16, hitting a low of 7.3385, marking the first time in 2023 that the rate dipped below the crucial threshold of 7.33. Concurrently, the onshore yuan mirrored this downward trend, with the yuan against the dollar also dropping throughout the night session, ultimately reaching a low of 7.2989.

On August 17, China's central bank released a report affirming, “The yuan exchange rate is in line with fundamental economic conditions” and emphasized that “The yuan will not depreciate unilaterally; it will remain subject to two-way fluctuations.”

The offshore yuan approached a significant level of 7.35, a nine-month first, before rebounding by over 500 points due to market reactionsBy 9:56 a.mBeijing time on August 18, the exchange rate had risen to 7.2886, breaking the streak of consecutive declines.

The primary driver behind the depreciation of the yuan is the widening interest rate differential between the yuan and the dollar.

Currently, the dollar finds itself in a “cold cycle,” as the Federal Reserve continues to raise interest rates while also reducing its balance sheetAdditionally, the US Treasury is significantly increasing debt issuance, further spurred by Fitch's recent downgrade of the US's sovereign credit rating, causing medium- to long-term US Treasury yields to rise

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Conversely, China is caught in a “hot cycle” of monetary easingAs the interest rate gap with the dollar widens, this necessarily results in a depreciation of the yuan.

On August 15, the People's Bank of China (PBOC) announced a minor reduction of 0.15 percentage points in the Medium-term Lending Facility (MLF) interest rate and a 0.1 percentage point decrease in the open market reverse repo rateThis adjusted the one-year MLF bidding rate from 2.65% down to 2.50%, while the seven-day reverse repo rate was cut from 1.90% to 1.80%.

In our mid-year analysis meeting, we discussed China's ongoing debt deleveraging, which inevitably tightens liquidity and necessitates expansionary monetary policies as a countermeasureThe recent rate cuts are a direct response to heavy economic debt that has entered a vicious cycle, aimed at maintaining bank interest margins, thereby encouraging banks to lower lending rates and even reduce existing loan rates to stimulate the balance sheets of households and businesses. The delicate balance of dollar tightening to combat inflation versus yuan expansion to combat deflation is effectively reflected in the currency exchange dynamics.

A pertinent question arises: What effects will the depreciation of the yuan yield?

First and foremost, it serves to stabilize dual circulation, invigorating the Chinese economy and securing market expansion.

For external circulation, a depreciation in exchange rates provides a direct reduction in the cost of export goods

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This opportunity affords Chinese foreign trade enterprises, particularly those reliant on domestic raw materials and components, greater profitability and pricing flexibility.

Manufacturing nations deeply impacted by the dollar’s cold cycle—including Germany, Japan, South Korea, and even the US—are currently beset by rising inflation, particularly in production costs, where employee expenses are on the rise as wellIn the international markets burdened by inflation and interest rate hikes, consumer purchasing power is dwindling, shifting preferences toward affordable yet quality products.

For instance, for global electric vehicle giant Tesla, which operates plants worldwide, its production model has adapted to the market realitiesWith the surging demand for electric vehicles this year, Tesla has ramped up production at its Chinese facility to serve global markets instead of increasing capabilities in the US or EuropeIn June, nearly 19,468 domestic Teslas were exported—marking an incredible 20.11 times increase from the previous yearIn July, this number reached 32,862, demonstrating the rapid production expansion and lower costs being achieved at Tesla's Chinese facilities, which translates into higher profit margins and competitive advantages in the supply chain.

Retaining foreign demand is also crucial; stabilizing foreign trade is likely to continuously boost industrial recovery in ChinaIn July, the purchasing managers' index (PMI) for Chinese manufacturing stood at only 49.3%—though it indicated a slight recovery over two months, with the new orders index increasing by 0.9% from June, it still does not suffice! External trade and industry continue to face pressure, and the depreciation in exchange rates may relieve some of that burden.

Exchange rate depreciation not only promotes exports but also suppresses imports, converting it into domestic demand and stabilizing the internal circulation of the economy.

Second, it encourages the internationalization of the yuan.

As the availability of dollars dwindles globally, the costs of financing have surged

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Meanwhile, the yuan has become relatively cheaper, providing an alternative to the dollar in international trade financing.

On the flip side, depreciation may weaken confidence, adversely affecting foreign direct investment and sparking capital outflows.

The widening interest differential between China and the US not only invites some capital outflows, but if the yuan depreciates excessively, it may undermine the confidence of foreign investmentFor instance, consider an investment of $100; if a depreciation occurs and it reduces in value to $90, will potential profits offset that currency gap?

Currently, the dollar is in a cold cycle, leading to a decline in global cross-border investmentIn 2022, worldwide foreign direct investments fell by 12%, whereas China saw a reverse trend of 6.3% growth in attracting foreign capitalHowever, reports from the United Nations Conference on Trade and Development indicate that global foreign investment will decline further.

The Ministry of Commerce previously stated that in the first half of 2023, the actual amount of foreign investment utilized in China saw a slight year-on-year decrease of 2.7%, signifying clear downward pressure.

This observation spans both direct and financial investmentsThe depreciation of the yuan may accelerate foreign capital divesting from Chinese assets, hence escalating pressure on the Chinese financial market.

Moreover, in terms of imports, the depreciation of the yuan could ignite higher costs for imported resources, thus intensifying inflationary pressure via imports.

Nonetheless, according to data released by the State Administration of Foreign Exchange, in July, the proportion of foreign exchange receipts and payments in renminbi surpassed 50.18% for the first time, significantly easing the inflationary pressures tied to external imports.

However, should energy and commodity prices continue to rise in the latter half of the year, China may face increasing production costs, putting pressure on export profits and counterbalancing the benefits of the yuan’s depreciation.

Thus, currency depreciation must be controlled.

This necessity explains why in the second quarter of the 2023 macroeconomic policy report, it was particularly indicated, “to rigorously guard against excessive fluctuations in the exchange rate and maintain the renminbi at a reasonable and balanced level of basic stability.”

When comparing the monetary cycles of China and the United States, the Fed’s interest rate hikes and balance sheet reductions are nearing their limits, with skyrocketing US Treasury yields leading to interest payments on budget deficits approaching an unprecedented $1 trillion, even surpassing military expenditures, while total national debt growth appears to spiral out of control

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