Strong Dollar Sends Yuan To New Lows, And No One Is Bothered

THE YUAN HAS fallen to a record low against the US dollar since it became internationally convertible in 2011 when Beijing allowed some overseas fund-management and securities firms to invest their yuan onshore.

This point has been coming. The People’s Bank of China has been letting the currency fall, managing only the speed of the descent with its trading band mechanism.

With inflation relatively low by world standards at 2.5% in August, China has the headroom to take the inflationary hit from a depreciating currency that makes imports more expensive. The intention is that the boost the falling yuan will give to exporters will revitalise an economy whose growth has slowed.

However, exports now account for only around 20% of the economy. A cheaper yuan will go only some of the way to offsetting the effects of zero-Covid lockdowns and a deeply troubled property market that is looking more and more like a structural, not cyclical, problem.

Raising interest rates to defend the currency would only worsen the property sector’s malaise. To the contrary, cutting them has been part of Beijing’s stimulus toolkit.

The yuan is far from the only currency to be battered by the US dollar’s strength. The euro, yen and British pound are all reeling from the US Federal Reserve’s aggressive raising of interest rates to bring down US inflation that has proved more persistent than expected.

The Federal Reserve will not abandon that policy soon. So far, US exporters have not been squealing about how the strong dollar is hurting them, as happened in the run-up to the Plaza accord in 1985. That international agreement to the US dollar led to the endaka shock to the economy of Japan, then playing the role China has recently taken as exporter to the world.

We are not at the point of a re-run of that yet. Neither China nor the United States have a short-term incentive to alter their currency’s trajectory. That point will come, but the question is whether it arrives before or after the Fed thinks it has tamed inflation.

However, just recall, a decade ago Beijing was being accused of being a currency manipulator for keeping the yuan low.

China Pumps Up Its Currency, But To What End?

China’s most recent manufacturing data showed recovery spluttering with exports soft, yet the yuan follows that by hitting a 19-year high agains the dollar. More intriguingly, the People’s Bank of China has let the currency rise within the allowable limits of its daily trading band; the yuan can rise or fall by 1% from a daily reference rate fixed in the morning by the central bank.

The yuan certainly isn’t off the leash, but the central bank is giving it more latitude of late than it has in the past. The currency has gained five times as as much so far this year as it did in all 2012. The question is whether this is part of the central bank’s preparations to open further China’s capital account, a next step being to widen the daily trading band of the currency. Those of that view latch onto the words of PBoC deputy governor Yi Gang who told last month’s annual meeting of the International Monetary Fund in Washington that the band would be widened “in the near future.” The previous revision was announced in April last year, when the band was doubled.

Another doubling might  be on the cards. If it is, it would most likely be to get the currency swiftly to an equilibrium level with the dollar as much as anything. The aim would be to discourage the present one-way bet on appreciation that currency speculators now regard the yuan to be. Policy makers are exasperated by that. They  consider the yuan to be close to where it should be against the dollar (real trade weighted value might be another thing, though). Except in exceptional circumstances most freely convertible currencies aren’t so volatile on a daily basis that they bounce around in a 4% range, so there doesn’t seem much need to widen the band just to accomodate regular daily trading fluctuations.

Yuan Shored Up Against Pressure From Washington And Tokyo

The U.S. Treasury has, as has become its custom, again declined to label China a currency manipulator. Its latest semi-annual report to Congress does say the yuan’s effective exchange rate remains “significantly undervalued” against the dollar, though it acknowledges that the Chinese currency has appreciated by 33.8% by that measure since currency reform started in 2005. It again calls for more exchange rate flexibility on Beijing’s part. All pretty much par for the course, and intended for domestic political consumption as much as anything.

More weight is given to its call for stronger policy changes on Beijing’s part to embed rebalancing. The Treasury remains concerned that the lessening of the surplus on the external account isn’t “enduring”. “Without more forceful structural reforms to promote domestic consumption, there is a risk that China’s imbalances will re-emerge as the global economy recovers,” it says. There would be little disagreement from this Bystander that further exchange rate reform is a necessary if far from sufficient condition for rebalancing.

In the meantime, the People’s Bank of China seems to have been intervening in the foreign exchange markets again on a large scale with activity intensifying since the fourth quarter of last year. The reversal in the slowing of foreign exchange reserve accumulation seen in the first three quarters of 2012 points to this.

This may as much as anything be being driven by the weakening of the yen ever since it became clear that Shinzo Abe would become prime minister last November. Though the official line in Tokyo is that the new government and its newly installed governor of the Bank of Japan aren’t targeting exchange rates, a weaker yen is a necessary precursor for the aggressive monetary policy aimed at achieving an domestic inflation target of 2% to work. Washington says it is monitoring the yen closely. With the yuan still closely tied by its 1% band to movements in the dollar, so is Beijing.

Yuan-Yen Direct

Direct trading between the Chinese and Japanese currencies starts Friday, cutting out the dollar as an intermediary. Rates will be posted in Tokyo and Shanghai, with China’s monetary authorities allowing a 3% daily trading band for the yuan against the yen (the dollar gets a mere 1% band).

And so Beijing takes yet another step along the long road to the internationalization of the yuan. How long before the won joins in, a likely next step given the plans for a free trade agreement between China, Japan and South Korea?

There is no particular reason for trade not involving the U.S. to be exposed to the potential volatility of the dollar. Direct currency settlement should increase yuan settlement of China’s imports and exports, as it lessens the currency risk for Japanese and South Korean buyers of goods denominated in yuan. The same idea is behind plans for an agreement between China and its fellow Brics, Brazil, Russia, India and South Africa, to make loans in their own currencies to facilitate trade. The five Brics plus Japan and South Korea account for about 30% of world GDP, compared to 45% for the U.S., the U.K. and the Eurozone.

Greater use of the yuan in trade could eventually grow into full convertibility of the currency. Before then, though, there will need to be a loosening of China’s capital controls and more opening of China’s capital markets. Both represent a greater political challenge than expanding trade finance. Opponents of reform have been able to argue that China’s national interest has been well served by cross-border capital controls and the ring-fencing of the country’s financial system. Only beyond that still distant horizon lies reserve currency status.

China: One Currency; Two Yuans

London has made more than one fortune on the China trade, though they have not all ended happily. Whether the yuan will end up as the new opium is the question raised by George Osborne, Chancellor of the Exchequer as the U.K. calls its finance minister, who has been in Hong Kong to promote a scheme to make London the leading international center for trading in China’s currency. London and Hong Kong have been talking about how to do this since last summer. Osborne’s trip will continue the talks.

Chatham House, a think tank in London, has forecast that trade transactions settle in the currency would reach the equivalent of $1 trillion by 2020. Yet, while Beijing has been taking baby steps towards making the yuan a fully convertible currency, there is still a long, long way to go. It remains an aspiration as much as anything but also a hostage to the pace of financial reform, which, as we have noted before, is in stasis during the leadership transition. China may need to rebalance its economy away from export- and investment-led growth and towards domestic consumption, for which financial system reform is a necessary if not sufficient condition, but vested political interests stand in the way. For all the wishful thinking in some parts, the Chinese currency is far from displacing the dollar as the world’s reserve currency, or even having the standing of the yen or the euro in such circles.

If anything, the surprise is that the offshore market for yuan is as large as it is (yuan deposits in Hong Kong total the equivalent of $80 billion). Normally the deepening and development of domestic financial markets and the easing of capital controls is prelude not postscript. In China, the first two are so difficult that the third is the easier option, even if by having a government controlled onshore yuan market in China and market driven offshore yuan market in Hong Kong and London, China may well end up, not untypically, with one currency but two yuans.

London, of course, will be happy to take its skim off both.

China’s Policymakers Smile On A Stronger Yuan

China’s policymakers may not be too sorry, for once, to see the yuan hit its highest value against the U.S. dollar since 1993. This week alone has seen the currency rise 0.7% against the greenback, its largest weekly jump in four years. By the standards that Beijing has imposed on the tight management of its currency, and its resolute opposition to letting the yuan appreciate except to its own timetable, it is a dramatic rise.

Long-term, it has always been in China’s interest (and policymakers’ plans) to let the currency appreciate towards market-driven levels in order to support the effort to reorient the economy away from export-led growth and towards domestic consumption. But a number of short-term factors have come together to make a stronger yuan desirable now.

It will help in the fight against inflation, which hit a three year high of 6.5% in July. It will slow the accumulation of dollar-denominated foreign-exchange reserves at a time when Chinese officials worry about the erosion of the their value in the face of the U.S. deficit debacle, and July’s trade surplus, the largest in two years, will swell them further. It, up to a point, would also pre-empt further inflationary impact on China of a further round of quantitative easing in the U.S., should the U.S. Federal Reserve may good on some hints that that might be necessary if U.S. GDP growth remains tepid, and, even more intangibly, it stocks up some international goodwill for Beijing as it makes China look to be a responsible team player in the face of a potential ‘double-dip’ global economic slowdown.

Most important of all, as far as the internal debate on the currency goes, appreciation would not be happening in the face of foreign, particularly U.S., pressure to let it happen. Whether there is a fundamental shift towards liberalizing China’s exchange rate policy about to happen, or, as seems more likely to us, a cautious step in that direction through, say, widening the bands within which the yuan is allowed to fluctuate each day, it won’t come without some cost to the rest of the world. The dollar, by definition, would fall and U.S. Treasury yields rise, if not disruptively; China would export some of its inflation. Many of these effects would, of course, net out across the global economy, such is the arithmetic of current accounts. How smoothly that would go depends as much as anything on what progress China can make in liberalizing its domestic financial markets. That is the biggest missing piece in making the arithmetic of canceling out the global imbalances work out.

Yuan Rising

By breaking through an exchange rate of 6.50 yuan to the dollar on Friday, China’s currency passed through one of those symbolic milestones beloved of market commentators. Thumbing through our records we see that level was last reached in 1993. A lot of Chinese exports have flowed under the bridge since then.

While a spurt of yuan appreciation usually precedes Sino-American talks (there is a round due in Washington mid-May), the People’s Bank of China seems now to be  belatedly letting the yuan shoulder more of the burden of fighting inflation, by making energy and food imports cheaper. The currency has gained almost a full percentage point against the dollar this month, as much as it was allowed in the whole first quarter. Since Beijing freed the yuan from its dollar peg in 2005, with a near two-year repegging after the global financial crisis hit in 2008, the yuan has gained 27.5% against the dollar under the central bank’s managed appreciation regime. Since it was unpegged for a second time in June 2010 the yuan has appreciated 4.6% against the dollar, though it has depreciated in nominal effective terms.

As the chart below, from the World Bank, shows, the yuan’ effect exchange rate has been trending up if not by as much as the nominal figures for its appreciation against the dollar might have one imagine. REER stands for real (i.e. inflation-adjusted) effective exchange rate (the value against a trade-weighted basket of currencies),  NEER for nominal effective exchange rate. Note the widening gap between the two since mid-2010 during which time exports have been resurgent.

The question for investors now is whether April’s appreciation against the dollar signals a willingness on the central bank’s part to step up the pace of appreciation of the currency in the face of stubbornly high inflation, or, as we suspect, just that it plans to continue to let the yuan rise as it has been doing.

China Puts A Number On Hot-Money Inflows, And It’s Small

China’s policymakers have long pointed an accusatory finger at the impact of hot-money inflows on inflation and asset bubbles. To what extent that is true has been difficult to assess. Quantifying such speculative investment inflows is tricky. In essence, analysts look for foreign-exchange reserves not explained by traditional transactions such as trade and foreign direct investment.

The State Administration of Foreign Exchange (SAFE) has taken a stab. The numbers it comes up with are $75.5 billion for 2010, and, after netting out cross-border yuan settlement, $35.5 billion, which is equivalent to 7.6% of the year’s total increase in foreign-exchange reserves. By way of comparison, SAFE reckons, total hot-money inflows in 2009 were $29.1 billion and averaged $25 billion a year over the previous decade, accounting for the equivalent of 9% of annual foreign-exchange reserve increases on average. (The is no netting out number as cross-border yuan settlement is recent.)

The numbers suggest that hot-money inflows account for a relatively small part of capital inflows, and are but a spec compared to the size of the economy as a whole. They took a large leap last year and any extra irritant to inflation is unwelcome to policymakers struggling to drain the excess liquidity from the economy in a controlled and orderly way. They also suggest that China is having increasing difficulty in maintaining effective foreign-exchange controls.

Inflating The Yuan’s Value, Not Manipulating It

The U.S. Treasury has danced its way, as is its wont, around designating China as a currency manipulator. In its latest half-yearly report to the U.S. Congress, it says that China’s high inflation means that the yuan’s real (inflation-adjusted) exchange rate with the U.S. dollar has risen by an annualized 10% since Beijing started allowing its currency to rise again against the greenback last June. On a nominal basis the yuan rose 3.7% over that time.

Were the Treasury to declare that Beijing was manipulating its currency, it would trigger retaliatory actions by the Congress, where many believe that it does. That, though, would be a ramping up of Sino-American tensions that neither government would want to deal with, especially in the wake of President Hu Jintao’s state visit to Washington last month that put the relationship on a less overtly confrontational footing.

The Treasury did, however, repeat another of its favorite tunes, that the yuan remains “substantial undervalued” agains the dollar, and that more rapid progress is needed in its revaluation.

China’s real effective exchange rate has appreciated only modestly over the past decade. China’s large increases in productivity in export manufacturing, improvements in transportation and logistics, and China’s accession to the WTO all suggest that the [yuan] should have appreciated more significantly on a real effective basis over this period.

To seek to change that, the Treasury strikes a note of encouragement, rather than chiding:

It is in China’s interest to allow the nominal exchange rate to appreciate more rapidly, both against the dollar and against the currencies of its other major trading partners. If it does not, China will face the risk of more rapid inflation, excessively rapid expansion of domestic credit, and upward pressure on property and equity prices, all of which could threaten future economic growth. By trying to limit the pace of appreciation, China’s exchange rate policy is also working against its broad strategy to strengthen domestic demand. And China’s gradualist approach on the exchange rate also adds to the substantial pressure now being experienced by other emerging economies that run more flexible exchange rate systems and that have already seen substantial exchange rate appreciation.

Beijing’s policymakers know that that to be the case. They are just doing a slow foxtrot with the yuan for domestic social and political reasons, and won’t be rushed into picking up the tempo.

Another Small Step In The Yuan’s Internationaliztion.

Bank of China’s new if limited yuan trading facility for its U.S. customers is another small step in the direction of internationalizing the currency. It is the first time customers can to buy and sell yuan using accounts at the state-owned bank’s U.S. branches, rather than go through Hong Kong. A limit of 20,000 yuan ($3,000) a day can be bought per individual’s account, the same cap that applies in Hong Kong to limit speculation. Business accounts are uncapped.

Beijing has been pushing its importers and exports to settle trade less in dollars and more in yuan, and allowing the development of an offshore market in the yuan. Cross-border trade settlements in Hong Kong grew from an average of 4 billion yuan a month in the first half of last year to 68 billion yuan in October. China Bank of Construction forecast recently that this number could reach 1.6 trillion yuan a month by 2015. However, the trend is more pronounced in the trade with countries other than the U.S.

Nevertheless, it has helped swell the yuan deposit base in Hong Kong to 260 billion yuan at end-November 2010, and the introduction of markets in the currency and of yuan-denominated financial instruments, including so-called dim sum bonds. Trading in the currency was allowed in Hong Kong last July. Daily trading has now reached $400 million. Given $4 trillion is the total of all daily currency trading, the internationalization of the yuan still has a long way to go, but it is clear where it is headed however cautiously.