On February 25, investors anxiously reacted to the rapid depreciation of the Chinese renminbi, which plunged to a six-month low against the dollar, by instigating a massive sell-off of the currency. The renminbi dropped almost 1 percent in the last week, a minor movement by most standards, but a pendulum swing not experienced since 2012.
The sudden depreciation of the renminbi, also known as the yuan, rattled many investors who have taken large, long-term positions on the currency on the basis of its historic stability. The official stance of the Chinese central bank has been to steward the yuan to a graduated appreciation against the dollar, a fiscal concession to critics who argued that China artificially depreciated its currency to boost the competitiveness of its exports. As a consequence of the appreciation, foreign money has been flooding the Chinese market, often strategically circumventing currency controls. Prior to the sell-off, the inflation-adjusted yuan had gained 43 percent against its primary trading partners since the Chinese central bank jettisoned its strict dollar-peg in July 2005.
Theories about what has prompted the dramatic skid of the yuan’s value abounds. However, what is now a matter of established fact is that the currency slide is not the result of unmanaged market forces but was rather intentionally engineered by China’s central bank which has also set a weaker benchmark against which the yuan can trade. The seven-day repo rate dropped to a nine-month low of 3.09% this week. Further, the central bank has aggressively intervened into its own currency market by ordering state-owned Chinese banks to buy more dollars and dump the yuan, effectively lowering interest rates.
While the yuan has become increasingly important as a vehicle of international exchange, it is not freely convertible. The central bank determines its daily trading value as a matter of fiat, allowing it to fluctuate modestly within a narrowly delineated range against the dollar. Still, it has become one of the world’s most used currencies, surpassing the Singapore dollar and Hong Kong dollar this year to become the eighth most used currency for transactions. In the past three years, the yuan has overtaken twenty-two currencies to grab a global market share of 1.29%. The yuan also overtook the euro to become the second most used currency in trade finance.
Experts have formed a consensus, despite persistent denials from Chinese authorities, that the forced depreciation of the yuan is an indication of concern on the part of the country’s central bankers, either regarding a sharp slowdown of its domestic economy or of the global economy. One well-rehearsed position shared by many analysts is that the People’s Bank of China (PBOC) was worried about the deluge of capital inflows in the last few months and wanted to demonstrate that the yuan is not a one-way bet. Pen Wensheng, an economist with the China International Capital Corporation, a research group, favors this theory. “The central bank would like to have more two-directional moves in the exchange rate to curb the big inflows,” he said.
David Loevinger, former senior coordinator for Chinese affairs at the U.S. Treasury Department, agrees: “Whenever there’s been a sharp appreciation of the yuan, the PBOC always pulls it back a bit. They want to inject two-way risk into the market and they want to shake out speculative inflows.”
Speculators who take a long-yuan and short-dollar position have only further contributed to the yuan’s volatility. Investors have also used the dollar-yuan trade as an instrument to exchange their currency positions for much higher-yielding and longer-lasting onshore alternatives, which includes ten-year local government bonds. The point of this strategy is to inject two-way risk into a currency known as a one-way bet, which should restrain the future growth of trade-related inflows that could seriously impair the government’s plans to de-leverage some parts of the economy, overhaul the financial sector, elevate the yuan’s status in the global monetary system and, ultimately, rival the U.S. dollar.
Chinese banks absorbed more than $73 billion in foreign currency in the onshore markets in January alone, a monthly record. In general, inflows have been sharply increasing since the middle of last year when China’s deep foreign exchange reserves grew from $500 billion to an astounding $3.8 trillion. PBOC officials denied any reason for concern. In a publicly released statement, they insisted the depreciation was fiscally routine. “The recent movement of the renminbi exchange rate is the result of market players adjusting their near-term renminbi trading strategies. The degree of exchange rate volatility is normal by the standards of developed and emerging markets. There is no need to over-interpret it.”
By lowering the value of the yuan, the PBOC is assuming a defensive position against currency speculators who continue to bet on its unabated rise. The PBOC is essentially compelling the yuan to behave more like a market-driven currency, which is part of an overall plan to completely overhaul the economy so it is less dependent on both foreign investment and exports. Eventually, China’s intent is to allow its yuan to float more freely in the open global market and has already signed special agreements with Singapore, London and Frankfurt to trade its currency more liberally. Jens Nordvig, a director of currency research at Nomura Holdings Inc., said, “They’re getting ready for a more flexible situation. They want to have some two-way risk embedded in the market before they take that step rather than hitting the strong end of the band in the new regime immediately.”
Investors are nervous about the future of their positions on the yuan. Nordvig said, “We are not used to volatility in the Chinese currency. It’s very painful for market participants because, in a low-volatility environment, it’s possible to carry large positions.”
Some experts are worried that the depreciation of the yuan could have a contagion effect, infecting the Taiwanese dollar, Japanese yen and Korean won. In a recent note issued by Barclays Bank, analysts surmised this could be possible if the depreciation continues. “If we are looking at the beginning of some competitive depreciation – aimed at supporting exports and growth – the contagion implications are greater. In such a scenario, we would expect investors to turn more defensive on regional currencies on expectations that policymakers elsewhere could adjust their currency strategy,” the note said.
Paradoxically, up until now most of the attention devoted to the Chinese yuan has focused on its incremental appreciation, stoking fears that already rising costs would only become even more prohibitively high. Among significant Asian currencies, only the yuan and the Korean won strengthened during 2013. The “redback” rose 2.8% against the U.S. dollar for the year, hitting record highs.
Most currency analysts don’t expect much more depreciation. Yao Wei, a China economist at Societe Generale SA in Hong Kong, said, “More depreciation? Probably not much more. Although the central bank does not like too much capital inflows, too much outflows will not be its choice, either.”
Bloomberg surveyed fifty-six analysts from major investment banks and the median forecast of the group was for the yuan to rise 2.6% by the end of the year to 5.97 to the dollar.