China's offshore yuan hits strongest in four years ahead of Trump-Xi meeting

The offshore yuan reached the strongest level against the dollar in four years, according to market reports. This surge occurred ahead of the upcoming meeting between US President Donald Trump and Chinese leader Xi Jinping, which could potentially ease some trade tensions. The onshore market also saw the yuan strengthen by approximately 0.15%, with traders anticipating its third consecutive weekly gain. Bank of America predicts the yuan to increase by an additional 1.6% by the end of the year.

Key factors driving this appreciation include the conversion of export proceeds and the undervaluation of the Chinese Yuan (CNY). Furthermore, there is growing pressure from the G7 to address trade imbalances. The offshore yuan reached 6.6956 per dollar in early morning trading, marking the strongest level since July 2022. Similarly, the onshore yuan traded at 6.6983 per dollar, its highest level since January 2023.

Despite the dollar index gaining earlier in the week due to the US Federal Reserve's rate hike, the rally weakened on Friday. Industry experts note that the yuan's appreciation trajectory has diverged from its previous close correlation with US-China yield spreads. This change is attributed to Chinese exporters holding substantial amounts of foreign exchange and the increasing expectation of CNY appreciation.

Consequently, fewer companies are now willing to chase yield spreads due to concerns about losing ground in the currency movement.

However, if the Federal Reserve becomes more hawkish, yield spreads may widen, potentially enticing more investors back into the market and exerting downward pressure on the CNY. Another potential downside risk for the yuan comes from China's deflationary risks. While weak domestic demand helps maintain a high current account surplus, it also poses debt deflation risks that could lead to capital outflows during a stress scenario.