China’s yuan adds renewed momentum to global reflation trade

China’s yuan is overvalued, and that could end up stoking global inflation.

The yuan ranks as the most overvalued among 32 major currencies in real effective exchange rate terms, an analysis of JPMorgan Chase & Co. indexes show. As Chinese exports are ubiquitous across a range of goods, the strength could translate into quicker inflation globally, adding to investor expectations for tighter central bank policies.

The potential impact from the Chinese currency’s inflation-adjusted strength is a reflection of the nation’s quicker economic recovery from the pandemic, and its importance as the factory of the world. Since July, the yuan has advanced more than 5% against a basket of major trading partners, which includes the euro and the yen.

“China could start to lead global inflation higher,” said Kota Hirayama, senior emerging-market economist at SMBC Nikko Securities Inc. in Tokyo. “Reflation is likely to accelerate” with increasing upward pressures on bond yields, he said.

The yuan’s real effective exchange rate is about 2.8 standard deviations higher than its five-year average, according to an analysis based on JPMorgan’s indexes. The differential is the widest among 32 major currencies measured.

Even though the Chinese currency has also suffered from recent dollar strength, it has held up better than almost every other Asian peer—a sign of how investors view the economies of China and the U.S. as the twin engines of global growth. And while concerns about the pace of a U.S. recovery is transmitted globally through Treasury yields, China’s impact would come from its exports of goods from electronics, appliances, and clothing to medical and chemical products.

Of course, strength in the yuan may also dent Chinese shipments. Exports had surged 30.6% in March from a year ago, though that was lower than the 38% expected in a median forecast of economists.

There are already signs that price pressures are building in China, with its producer-price index rising at the fastest pace since 2018 last month. The U.S.—the Asian nation’s biggest export market—also recorded the biggest advance in the cost of living in almost three years.

To be sure, modeling by the Institute of International Finance indicates the yuan is undervalued by 12.8%, according to its latest assessment published in March. The report also shows that the dollar has become increasingly overvalued.

JPMorgan’s index of the yuan’s real effective exchange has climbed almost 8% from a June low to hover near an all-time high. The elevated rate is due to the stronger nominal yuan and a faster pace of increase in China’s cost of living compared with other countries, according to Dariusz Kowalczyk, chief China economist at Credit Agricole CIB.

“The elevated REER is a challenge for some exporters, but for most it is acceptable given China’s relatively fast productivity gains,” said Kowalczyk. “Productivity gains have by far exceeded real appreciation over the long run, and also in recent years, hence exports are so strong, and should remain so.”