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China’s currency
Bending, not breaking
As the Fed mulls a rate rise, the yuan comes under pressure again
Jun 4th 2016 | From the print edition
AS CASH poured out of China at the start of this year, hedge funds lined up to bet against the yuan. Many thought it only a matter of time before the government ran down its foreign-exchange reserves, forcing a big depreciation. Publicly, Chinese officials scoffed. “Declare currency war against China? Tee hee,” was the front-page headline in a newspaper. Privately, they took the threat more seriously. They fought back on multiple fronts, intervening both at home and abroad to prop up the yuan, while tightening capital controls. The battles have gone China’s way so far: it has slowed the outflow of cash and the yuan is right where it found itself in early January.
Yet the Chinese authorities’ apparent success prompts two questions. The first, of immediate concern, is whether the stability will endure when the Federal Reserve raises interest rates again. For all China’s forceful actions to prop up the yuan, the biggest factor in its favour was arguably external, as the Fed turned dovish. At the beginning of the year investors were braced for a succession of rate rises in America, believing these would drive the dollar, already strong, even higher. But volatile markets and a patch of weaker data stayed the Fed’s hand. That restraint halted the dollar’s ascent and restored the lure of other currencies. The yuan was one obvious beneficiary, gaining 2% against the dollar from mid-January to mid-March.
This reprieve will soon be over. Janet Yellen, the Fed’s chairman, said last week that a rate rise is probable in the coming months. The dollar has started to climb higher against just about every currency, including the yuan. From May 30th to June 1st, the Chinese central bank set the yuan’s opening rate at its weakest level against the dollar in more than five years. That may be a good thing for China’s exporters, but the worry is that depreciation will trigger a resumption of the capital outflows that the bank has worked to curtail.
Yet China is in a better position than half a year ago to resist the pressure. Extensive capital controls remain intact, limiting speculators’ room for manoeuvre. The Chinese economy is itself stronger, thanks to a revival of the property market. And even if the Fed raises rates in June or July, it is expected to proceed cautiously thereafter, suggesting that any dollar rally will only go so far. Against this backdrop, the yuan will probably soften but is unlikely to tumble, says Zhang Lu of CEBM, an advisory firm.
The second question about China’s defence of the yuan is a more fundamental one: has it given up its goal of reforming the currency? For years it pegged the yuan to the dollar and intervened to limit its fluctuations. Last August the central bank introduced a new “exchange-rate mechanism”. It still sets a daily level against the dollar around which the yuan can move up or down by no more than 2%, but that is now based on two factors: the previous day’s closing rate and the value of a basket of currencies, not just the dollar. If implemented in full, the new system would give market forces a bigger role.
In practice, the central bank has retained considerable power. It can influence the yuan’s closing rate against the dollar by intervening directly or instructing state-owned banks to do so. In setting the daily rate it can also choose whether to focus on the dollar or on the basket, as suits its purposes. That is indeed how it has steered the yuan since January. When the dollar has been weak, the central bank has tethered the yuan to it, thereby allowing depreciation against the basket of currencies. When the dollar has strengthened, as in recent weeks, it has let the yuan creep down against it, thereby limiting its appreciation against the basket.
In other words, the central bank has hardly ceded control of the exchange rate to the market. That is not to say that its reforms are meaningless. The yuan’s daily exchange rate against the dollar has indeed been much more closely bound to the previous day’s closing level than in the past: the average difference between the two has been 0.009 yuan since August, compared with 0.06 yuan over the two years leading up to that (see chart). What is more, against the basket of currencies, the yuan has been broadly stable: its level today is almost exactly the same as at the start of 2015. Taken together, the revamped exchange-rate system has started to earn credibility in the eyes of some analysts and traders. It is certainly true that China has only gone part-way in freeing the yuan. But that is all it ever promised to do.
From the print edition: Finance and economics
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