The yuan’s weakness is a dilemma for China’s central bank

Dec 3, 2016 / The Economist

YUAN forecasters have had it easy for the past decade. But for a few isolated days, China’s currency has been a one-way bet for years on end, whether appreciating against the dollar, pegged to it or, more recently, depreciating. The pace at which it has risen and fallen has also been predictable: the central bank always made it gradual. So Guan Qingyou, of Minsheng Securities, thought himself on solid ground when he predicted in early November that the yuan would stay above 6.82 per dollar for the rest of the year. Less than a week later he was proved wrong: the yuan fell to an eight-year low. Mr Guan published an apology: the art of knowing the yuan’s future with any precision, he conceded, had become rather tricky.

Most analysts, investors and companies believe that the Chinese currency has further to fall against the dollar, but can only guess as to how far and how quickly. Their uncertainty reflects a new reality. The government, long able to exercise tremendous control over the yuan, has started to lose its grip. A new exchange-rate mechanism, introduced last year, has made the currency more flexible but also more responsive to global market trends. Dollar strength over the past two months has meant that the yuan, like just about every other currency in the world, has steadily lost ground against the greenback.

The central bank wants depreciation to be orderly. Indeed, compared with most other currencies, the yuan has outperformed since the start of October: it has stayed stable against a basket of currencies, which the central bank says is its primary target (see chart). But curbing declines against the dollar comes at a cost, eating into hard-earned foreign-exchange reserves. The yuan’s future pivots around this question: will China be able to restrain market forces and guide the currency to a soft landing, or will the dam break and mild depreciation turn into a rout?

Investors are so far more cautious about betting against China than at the start of 2016, when some built up big yuan short positions in the offshore market. The government made life painful for them, raising the cost of borrowing yuan offshore and stepping up capital controls to support the currency onshore. A prominent hedge fund owned by Carlyle, a private-equity firm, was among those to suffer big losses.

But if foreign investors are wary of another tilt at the yuan, sentiment inside China is turning more bearish. The currency has fallen 6% this year, and it will soon take more than seven yuan to buy a dollar, a psychologically important level. In real-effective terms (that is, against a trade-weighted set of currencies, controlling for inflation), the yuan is merely at a two-year low. But it is on the dollar exchange rate that most people still focus. Legions of entrepreneurs and ordinary households, who collectively have accumulated vast wealth, want to diversify their savings into other currencies. Read more…

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