China's yuan still seen weakening if dollar rebounds, but at more modest pace

The Chinese yuan will only give up some of this year's strong gains against the dollar over the next 12 months, provided the US Federal Reserve continues to tighten policy and gives the greenback a lift, a Reuters poll showed. Mainly driven by US dollar weakness and helped by China's tighter controls on capital outflows, the yuan is up more than 6 percent so far this year, with more than half of those gains coming in the last three months.
In August, the yuan posted its biggest monthly gain since the Chinese currency was revalued and taken off a fixed dollar peg in 2005. It was trading near a 15-month high of 6.53 against the greenback on Wednesday, and is close to recouping all of its stiff losses suffered in 2016. Reuters latest poll of nearly 60 foreign exchange strategists showed they continue to expect the yuan to soften in coming months if the dollar perks up, though they do not expect it to weaken as much or as fast as predicted just one month ago.
The yuan is expected to weaken to 6.70 in six months and then to 6.80 in a year, which would mark a retreat of around 4 percent from current levels, according to the poll conducted on September 4-6. That compares with the previous poll released in early August, which showed expectations of a pullback to 6.85 in six months and 6.90 in a year. But those expectations are largely dependent on the strength of the currency on the other side of the exchange rate - the dollar.
"Broad dollar weakness provides ample room for the PBoC (People's Bank of China) to allow a stronger CNY (yuan) without fear of losing international competitiveness," Carl Paraskevas, a senior financial economist at Lloyds wrote in a note to clients. "It is hard not to argue that much of the recent CNY strength has more to do with dollar weakness."
Late last month the greenback fell to its lowest in over 2-1/2 years against a basket of six major currencies on the expected hit to the economy from Hurricane Harvey and increasing concerns that tension in the Korean peninsula could escalate. "The bigger picture is that we believe the USD will not be materially stronger than where it is now a year out; if anything, a tad softer," said Vishnu Varathan, head of economics and strategy at Mizuho Bank in Singapore.
But not everyone is optimistic on the Chinese currency. "We are not convinced that the strength in the yuan so far this year is sustainable as we are still skeptical over the recent pickup in growth in China and have a bearish outlook for that," said Lee Hardman, currency strategist at Bank of Tokyo-Mitsubishi UFJ in London.
"We could also start to see capital outflows from China pick up again, which would put some downward pressure on the currency." China has posted forecast-beating economic growth so far this year, though many analysts believe it will eventually start to lose steam as higher borrowing costs and a cooling property market weigh on activity.
Some traders believe that authorities may start tapping the brakes on the yuan's strong ascent after a highly sensitive Communist Party Congress in October. Some Chinese exporters are already complaining of losses caused by the currency's sudden turnaround. Traders had expected the dollar to strengthen at the start of the year on expectations of faster Federal Reserve interest rate hikes and on hopes of fiscal stimulus from the US administration.
But President Donald Trump has so far disappointed markets by failing to deliver on his pre-election promises, weighing on the dollar's performance as hopes have faded for tax cuts. While the Fed is expected to announce plans to shrink its balance sheet as early as this month, comments from Fed members recently showed US policymakers were increasingly split on the outlook for inflation and how the lack of it might affect the future pace of interest rate rises.
Uncertainty over the dollar has helped maintain bullish bets on the Chinese yuan, according to a separate Reuters poll on currency positioning. Similarly, bets in favour of the Indian rupee were in place, though strategists see it softening over the next 12 months. Early last month, the currency hit 63.62 per dollar, its highest since July 2015. The Indian rupee has gained over 5 percent so far this year and was around 64.1 per dollar on Wednesday.
The currency is now expected to weaken slightly to 64.50 per dollar in six months and then to 65.00 in a year, unchanged from last month's poll. "Our stronger rupee view is premised on a weaker dollar, undermined by a lower probability of comprehensive US tax reforms by year-end, and risks of a more gradual pace of rate hikes next year," said MUFG's Hardman.