As the Chinese yuan continues its historic drop in value, many investors worry that the rapid depreciation, originally engineered by Chinese fiscal authorities, is now being dragged down by irrepressible market forces.
Since the conclusion of January, the yuan has dropped 3.4% against the U.S. dollar, an extraordinary movement given the past steadiness of the currency, tightly controlled by Chinese authorities. Even more discomfiting to many, the yuan is dipping in value at a more accelerated pace in the offshore market, where the currency is much more freely traded.
At least originally, the currency slide was 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. 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.
However, the decline of the yuan has continued even in the face of the Chinese central bank’s aggressive interventions, which included setting up a morning guidance rate that is much stronger for the currency, designed to lift its market value. A recent research note issued by RBS said, “A depreciating renminbi is symptomatic of a faster slowing economy and it can depreciate further.” If this is the case, the Chinese government may no longer be capable of reversing the currency’s descent.
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.
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What is an unanticipated disaster for so many long-term investors is a grand strategy for the Chinese banking authorities. 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.”
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.”
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.
The renminbi is typically valued against the U.S. dollar but it behaves very differently, and under different macroeconomic conditions. 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.
The quick devaluation of the renminbi frightened 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.
Hedge funds which have taken bullish positions on the renminbi are particularly vulnerable. Geoff Kendrick, a foreign exchange analyst at Morgan Stanley,speaking to the Wall Street Journal, estimates that $150 billion in renminbi investments remain exposed and the market-to-market losses could total $2 billion.