China is grappling with a slowing economy, yet its currency has rarely been stronger. The yuan is also outperforming the US dollar this year even as the Fed prepares to hike interest rates. So what gives?

The Chinese currency has soared more than 8% in 2021, according to an index that tracks the yuan's performance against 24 other currencies. Based on that gauge — the CFETS RMB Index — it is just 0.26% short of its previous record high set in November 2015.

The yuan has also gained ground on the dollar. The yuan has risen between 2.4% and 2.8% this year against the greenback — depending on whether it trades in China or offshore. Both versions are now at their highest levels against the dollar in three years or more. The offshore rate currently trades at 6.34 yuan per dollar, a level not seen since May 2018.

Headed into December, the yuan's gain this year was "the best in the world," said Marc Chandler, managing director for Bannockburn Global Forex, an Ohio-based capital markets trading firm.

Booming exports and hot money chasing comparatively juicy returns on Chinese government bonds are behind the surge "despite weaker economic growth," according to Becky Liu, head of China macro strategy at Standard Chartered Bank.

The currency's strong performance could continue into 2022, even as China's economy struggles with factory inflation, a major slowdown in real estate, and an ongoing regulatory crackdown targeting its private sector.

Liu expects the yuan to strengthen to 6.3 per dollar in the first few months of next year. Analysts at Goldman Sachs suggest the same could happen in the first half of 2022, for similar reasons. (In 2014, the offshore yuan touched nearly 6.01 against the dollar, its highest level since China conducted a landmark reevaluation of its currency in 2005.)

There are upsides to this trend. The stronger the yuan, the more likely central banks are to keep a lot of the currency in reserve, promoting its global use. It could also help to make imports cheaper and curb high inflation. China buys a lot of commodities that are priced in dollars.
But there's a pretty big downside if the currency appreciates too rapidly. For as strong as Chinese exports are right now, a pricier currency could also cause those exports to become less competitive abroad. Given how vital trade has been to China's economy, that could threaten an already fragile recovery.
Strong exports
China's economy has been hit in recent months by shipping disruptions and a deepening property crisis. A severe energy crunch, which has since eased, also contributed to the economy expanding at its weakest rate in a year last quarter.
Even so, Chinese exports have held up well. Shipments from China reached $325.5 billion in November, a 22% jump over the year before, according to government statistics released Tuesday. Exports through the first 11 months of the year have surged 31% to more than $3 trillion — more than all of 2020.
Analysts have attributed that performance mainly to strengthening demand for Chinese goods as the world recovers from the coronavirus pandemic. China, which has taken a zero-tolerance approach to Covid-19, has also largely avoided the disruption suffered by rival exporters, such as Vietnam and Indonesia, because of coronavirus outbreaks.

The main reason for the yuan's surge is the amount of money flowing into China, largely thanks to surging exports, said Larry Hu, head of China economics at Macquarie Group.
He said it's likely that exports will remain strong even as the world responds to the Omicron variant of the coronavirus, "if the experience from the Delta variant this summer is any guide."
Analysts at Standard Chartered also said last week that China's exports could get a boost as the United States increases shipping capacity. They pointed out in a research note that constraints on such capacity should ease as more US ports increase operations.
Betting big on Chinese bonds
Another reason for the yuan's rally, according to analysts, is the amount of international enthusiasm for Chinese bonds.
The value of yuan-denominated bonds held by international investors rose for the eighth straight month in November to hit 3.9 trillion yuan ($620 billion), according to the People's Bank of China.
Global investments pouring into Chinese bonds accelerated after FTSE Russell, the global index provider, in October added Chinese government bonds to its flagship World Government Bond Index. That's one of the world's most widely used global bond benchmarks.
Analysts at ANZ expect China's inclusion in the index to bring around $130 billion worth of investment to Chinese government bonds over the next three years. They also estimated that foreign investors will own 4 trillion yuan ($625 billion) worth of China's onshore bonds by the end of this year.

"Concerns over downside risks to China's near-term growth outlook will not deter foreign investors from increasing their allocation to Chinese assets, in our view, " the analysts wrote in a research report last month.
Global investors are chasing "attractive" returns from Chinese government bonds, they added. China right now offers a 10-year yield of 2.9%, compared to the US Treasury 10-year yield of 1.44%. The ANZ analysts expected those bonds to keep their appeal, helped by the low volatility of the yuan, which still does not trade entirely free of government intervention.
Stabilizing the yuan's rise
And Beijing may yet intervene to brake the yuan's rapid appreciation.
The People's Bank of China announced Thursday it would raise the foreign exchange reserve requirement ratio to 9% from 7% — the second hike in the ratio this year. The move will force Chinese financial institutions to keep more foreign money in reserve, and has been widely interpreted as an attempt to temper the yuan's rally.
"This is one of the strongest signals" that the central bank is uncomfortable with the yuan's pace of appreciation, wrote Gaurav Garg and Philip Yin, analysts for Citi, in a report on Friday.
The central bank had already warned last month that financial institutions and companies should refrain from making "speculative" bets about the yuan. Analysts said regulators are concerned that if the yuan is too strong, it will hurt the competitiveness of Chinese goods around the world. Financial markets could also be rattled by a rapid influx of capital if the currency appreciates too quickly.
"It is desirable for the [yuan] to stay largely stable [for] the Chinese authorities, in our view," said Liu from Standard Chartered.

Still, Liu expected that the odds remain low that China would deploy "heavy-handed direct intervention," such as directly buying dollars and selling yuan.
A US interest rate hike or two may also take some of the heat out of the yuan, as China heads in the opposite direction on monetary policy in a bid to boost growth.
"We still expect further gains in the yuan, but at a much more gradual pace," Goldman Sachs analysts wrote in a research report last month, noting that China's "key trading partners" have started to tighten policies.