Zhejiang Merchants Macro | A Grand Vision ( March ): An In-Depth Analysis of the Two Major Surplus Countries' Currency Rate Puzzle

(Source: Zhejiang Merchants Securities Research Institute)

The macro team at Zhejiang Merchants has launched a brand new research series in 2026: the Grand Blueprint series.

Books are the sediment of human civilization and the fruits of great research. The accumulation of past readings has provided our team with many valuable inspirations for our research work. Unlike traditional book recommendation lists and reflections, we will select a portion of books from our past and future diligent reading that hold profound insights into the future macro environment and carefully craft a research report. The report will focus on a core macro discrepancy in the current market and will explore the following thoughts: Do the conclusions in the book have enlightening significance for the present? What profound changes have occurred in the environmental context? In a new macro paradigm, what further explorations should we undertake on the conclusions while standing on the shoulders of giants? What different thoughts from market consensus can arise from this? What references can it provide for future allocations of major assets?

Through this, we hope that the Grand Blueprint series reports will provide institutional investors with insights and create an opportunity for intellectual exchange and a window to explore asset allocation opportunities.

——Lin Chengwei, Chief Macro Analyst at Zhejiang Merchants Securities

Why do the two largest countries with persistent current account surpluses face currency conundrums?

A director at the China Chief Economist Forum, with eight years of experience at the central bank, he participated in the formulation of the “12th Five-Year” and “13th Five-Year” plans in the financial sector. He ranked second in the New Fortune awards from 2022 to 2024, third in the Best Analyst category of the Securities Times in 2025, first in the Golden Unicorn Awards in 2025, and first in the Wind Gold Analyst awards in 2024.

With 9 years of research experience in the macro field, he previously worked at the State Administration of Foreign Exchange, focusing on overseas economic policy and cross-border capital flows. He ranked second in New Fortune from 2022 to 2024, and third in the Best Analyst category of the Securities Times in 2025.

Core Views

The balance of payments identity states that the current account balance plus capital and financial account balance equals zero. For a single country, this means that a current account surplus (deficit) equals a capital and financial account deficit (surplus). From a global perspective, the United States is a typical surplus economy in capital and financial accounts, while China and Japan rank as the top two countries in current account surpluses.

However, Japan and China have maintained strong external surpluses in their current accounts for an extended period, yet this advantage has not naturally translated into sustained strength in their currencies. Instead, both countries have faced significant depreciation pressures at certain stages. This phenomenon indicates that the key to determining currency trends lies not merely in the scale of surpluses but in how those surpluses are transformed into actual supply and demand in the foreign exchange market.

From a short-term perspective, based on three traditional exchange rate models, we find that the purchasing power parity theory fails to explain the exchange rate trends of China and Japan; interest rate parity theory applies to China but not to Japan; and an optimized balance of payments theory based on actual cash flow is more applicable to both China and Japan, providing a deeper analysis of the underlying reasons for the current account surpluses yet currency depreciation from the perspective of “surplus not collected.”

I. Traditional Exchange Rate Framework from a Short-Term Perspective: Three Models from Goods Pricing to Asset Pricing

The foreign exchange market is essentially a relative pricing market for cross-border assets, where exchange rates reflect not only the relative prices of goods and services between two countries but also the relative returns, risk premiums, and capital flow constraints of their financial assets. The three most common frameworks in traditional research—purchasing power parity (PPP), interest rate parity (IRP), and balance of payments (BOP)—correspond to the goods market, capital market, and foreign exchange supply-demand mechanisms.

II. Purchasing Power Parity: Fails to Explain the Exchange Rates of China and Japan

In practical terms, the explanatory power of purchasing power parity theory for the exchange rates of the Renminbi against the US dollar and the Japanese yen has been significantly declining. The core premise of this theory is that the prices of goods between different economies can converge through trade and arbitrage mechanisms, thereby allowing exchange rates to adjust around relative price levels. However, this does not hold true in reality: on one hand, the CPI does not equate to a basket of goods prices subject to international arbitrage; on the other hand, trade costs and policy barriers obstruct the “law of one price.”

III. Interest Rate Parity: Applicable to China, but Not to Japan in Recent Years

The interest rate differential between China and the US provides a stronger explanation for the Renminbi exchange rate; while the yen exchange rate is also influenced by the US-Japan interest rate differential, its explanatory power has significantly decreased since 2022, which we believe is related to the decline in the hedging ratio during global yen carry trade processes.

From Japan’s perspective, since 2022, the yen exchange rate has continuously diverged from the US-Japan interest rate differential. The dominant factors behind this divergence are no longer just the interest rate differential itself but the strong expectations for a stronger dollar under the “American exceptionalism,” the directional shifts in cross-border asset allocation, and the simultaneous adjustments in hedging behavior. Traditionally, yen carry trades involve low-cost yen financing, exchanging it for higher-yielding dollar and other foreign currency assets, with profits mainly arising from the interest rate differential between financing costs and asset yields. Meanwhile, foreign exchange hedging can lock in the exchange rate costs for forward settlements. This trading model involves both exchange and interest rate differentials, and the results can largely keep a high correlation between the yen to US dollar exchange rate and the US-Japan interest rate differential. Since 2022, when expectations for a trend of a stronger dollar began to form, global institutional investors have seen a decline in the hedging ratio during carry trades (including Japanese companies allocating overseas assets), with a key trading aspect also being the loss of pricing mechanisms, causing the traditional interest rate parity framework to have significantly less explanatory power for the yen exchange rate.

From China’s perspective, the Renminbi to US dollar exchange rate is strongly correlated with the short-term interest rate differential between China and the US, and it is better understood through the mechanism of retention and repatriation of foreign exchange income from current account surpluses. The key to this mechanism lies in the differences between balance of payments (BOP) and bank client accounts. The goods trade in the BOP is recorded on an accrual basis, reflecting the transactions corresponding to the transfer of ownership of goods between residents and non-residents; while bank client foreign payment records are based on cash basis, only reflecting the cross-border payments that enterprises and individuals actually conduct through domestic banks. For the Renminbi, the interest differential does not directly determine the exchange rate through carry trades, but rather alters the domestic foreign exchange supply and thus affects the exchange rate trend by impacting the retention, repatriation, and settlement timing of foreign exchange income for enterprises. Therefore, under the institutional arrangements where export income can be retained abroad, the Renminbi exchange rate often shows a higher correlation with the China-US interest rate differential; and the so-called “surplus not collected” in the BOP (the “result”) is essentially a reflection of this interest differential transmission mechanism in the balance of payments data (the “cause”).

IV. Balance of Payments Perspective: What is Japan’s Balance of Payments Structure? How Does It Affect the Yen Exchange Rate?

From the perspective of the balance of payments structure, Japan is no longer an economy that relies on merchandise exports to continuously generate foreign exchange inflows, but is gradually transforming into a country that supports its current account surplus through returns on overseas stock assets. Japan’s current core characteristics are: merchandise trade has shifted from surplus to deficit, long-term service trade deficits (the digital tenant dilemma), and first income stands out, but a significant portion has not formed genuine demand for yen repatriation; meanwhile, the financial account has long reflected capital outflows, especially with continuous expansion of foreign direct investment.

Mapping this to the yen exchange rate, in a traditional framework, an economy with a long-term current account surplus should have a currency supported in the medium-to-long term; however, Japan’s issue is that this transmission chain has been broken. Today, Japan’s current account surplus mainly comes from returns on overseas assets (reflected as first income under the current account), and over 60% of Japan’s first income is retained overseas for reinvestment without repatriation, representing book recognition rather than actual cash inflow. Therefore, Japan’s true cash-generating ability in the current account is significantly weaker than what is shown on paper. This is the key starting point for understanding the long-term weakness of the yen.

V. Balance of Payments Perspective: What is China’s Balance of Payments? How Does It Affect the Chinese Yuan?

From the perspective of the balance of payments structure, the biggest difference between China and Japan is that the pillar of the current account surplus remains merchandise trade, rather than returns from overseas stock assets. This means that China’s balance of payments foundation is still built on manufacturing exports and competitive commodity trade, rather than being driven by first income surplus like Japan. However, mapping this to the Renminbi exchange rate, the key is not whether the merchandise trade surplus can continue to reach new highs, but whether this surplus can be realized in cash flow terms with a higher conversion rate, which also presents the issue of “cash realization rate.”

The China-US interest rate differential and expectations for the dollar index will impact conversion efficiency from two main aspects: the first aspect is that a merchandise trade surplus may not necessarily convert synchronously into cross-border cash flows, as trade credit factors such as export receivables and import payables can weaken the transmission of nominal surpluses into cash flow surpluses; the second aspect is that once payments are received, enterprises may not immediately repatriate them and complete currency settlement, and retaining export income overseas further weakens the support of surpluses on domestic foreign exchange supply and the Renminbi exchange rate. Only when both conversions improve simultaneously will the surplus truly reflect the momentum for Renminbi appreciation.

VI. How to Outlook the Renminbi to US Dollar Exchange Rate in 2026?

From a short-term perspective, whether the logic of long-term appreciation of the Renminbi can be fulfilled depends not only on whether the merchandise trade surplus can maintain high levels but also on whether the realization rate, repatriation rate, and settlement rate of the surplus can improve simultaneously. A high trade surplus does not necessarily mean that there is a long-term basis for Renminbi appreciation, corresponding to three sets of indicators:

First, the expansion of trade credit under merchandise trade slows, and the export collection rate improves, indicating that the conversion efficiency from nominal surplus to cash flow surplus is increasing; second, the growth rate of corporate deposits overseas slows, and the willingness to retain export income abroad decreases; third, the settlement rate improves, meaning banks’ willingness to settle for clients improves, indicating that net inflows from cross-border transactions are beginning to flow back domestically and convert into domestic currency demand. Correspondingly, outlook for the Renminbi exchange rate in 2026:

First, whether the China-US interest rate differential exhibits a trend of convergence, which determines whether the opportunity cost for enterprises to continue to retain dollars decreases; with the intensification of the Iran conflict, we believe that expectations for Federal Reserve interest rate cuts will gradually converge or even potentially shift toward rate hikes; in contrast, the People’s Bank of China still has a high probability of cutting interest rates within the year, and the short-term interest differential may not converge, and there may even be a possibility of widening.

Second, the dollar index may maintain fluctuations within the range of 95-100, making it difficult to reproduce the trend of depreciation seen in 2025.

In summary, while China’s trade surplus is expected to continue to maintain high growth in 2026, the conversion efficiency from the cash flow perspective may decline. Based on this, we expect the central value of the Renminbi to US dollar exchange rate to be around 6.9 in 2026, with the high point in the first half of the year potentially reaching 6.8, and then gradually falling below 7, with quarterly central values of 6.8, 6.9, 7.0, and 7.0.

VII. From a Long-Term Perspective, the Central Value of Exchange Rates Ultimately Depends on a Country’s Factor Endowments and Their Evolution

Following this framework, Japan’s economy is long-term constrained by factors such as deepening aging, resource constraints, and although there are local breakthroughs in innovation, it is difficult to form a broad technological cycle, which determines that its total factor productivity and potential growth rate are unlikely to experience a trend uplift. Therefore, the yen does not have endogenous momentum for sustained appreciation in the medium-to-long term; in contrast, the medium-to-long term direction of the Chinese exchange rate is not dependent on short-term fluctuations, but on whether future total factor productivity can continue to improve, especially whether the technological innovation capability nurtured by China’s engineer dividend can be continuously transformed into breakthroughs in research and development, manufacturing upgrades, industrial chain transitions, and the cultivation of new productive forces, resonating with the accumulation of human capital, capital deepening, and institutional efficiency improvements, ultimately pushing the potential growth central value upward, which will be the core variable determining the Renminbi’s strength or weakness in the medium-to-long term.

Risk Warning

Continuous depreciation of the yen triggers joint intervention by the US and Japan; improvements in trade and service balances exceed expectations; and the convergence of China-US or US-Japan interest rate differentials is faster than anticipated.

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Editor: Song Yafang