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Yuan flexibility not enough for China

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1 Yuan flexibility not enough for China on Sat Jul 03, 2010 11:22 pm


Yuan flexibility not enough for China
July 4, 2010

What Are We To Do
Much to be anticipated on a gradual currency rise

An employee poses with Chinese yuan notes inside a bank in Taipei April 23, 2010. Now that China is staying true to its word and letting the yuan trade a bit more freely, analysts and investors outside the mainland may not be prepared for one potential outcome: a yuan drop. REUTERS/Nicky Loh/Files

MY earlier column, Realities About China’s BOP Surpluses (StarBizWeek, April 10, 2010), concluded: “…exclusive focus on China’s exchange rate policy is, I think, counter-productive. It will unlikely resolve the US’s persistent imbalance. However, as I see it, there is growing awareness in Beijing that greater exchange rate flexibility and a gradual yuan appreciation has to be an element of any credible package of policy measures for China to liberalise factor markets and remove cost distortions. This could transit over time to a full market economy. Any exchange rate adjustment has to be viewed in this context.”

Sure enough, the Peoples’ Bank of China (PBoC) announced on June 19 that it would allow greater flexibility for the yuan, thereby reverting to the flexibility it had enjoyed before the yuan was effectively re-pegged at around 6.83 per US dollar in mid-2008 to provide stability during the global crisis.

In the three years following an initial 2.1% revaluation of the yuan on July 21, 2005, the currency gained a further 19%. But in those first remaining months of 2005, the appreciation was only 8.6%.

Credibility requires serious action

China’s decision to allow flexibility back into the value of the yuan was greeted with “grudging optimism”.

Few think, and rightly so, the move will have a dramatic impact on rebalancing the global economy. Partly because of its limited size.

The yuan offshore forward market on the first trading day predicted an appreciation of just 2.3% by year-end; and 3% in 12 months. Based on an undervalued yuan estimated at between 25%-40%, this will take more than a decade to eliminate.

Partly because most regard any yuan adjustment as a helpful but not critical part of shifting consumer demand from the US to Asia.

Previous experience in 2005-2008 was accompanied by a soaring Chinese current surplus instead.

This was also the Japanese experience after the 1985 Plaza Accord, when Japan agreed to a major yen appreciation.

Stanford Prof R. McKinnon found little long-term change in Japan’s trade surplus with the US as a result. The lesson China has taken on board is that rapid swings in the exchange rate can be most damaging.

The PBoC has yet to release details of the new regime. But has hinted that

(i) its focus is to guide the yuan against a basket of currencies, in order to foster a genuine two-way movement between the yuan and the US dollar;

(ii) the “basis did not exist for a large-scale appreciation,” i.e. big exchange rate fluctuations “are not in China’s interest” and any movement in the yuan will be gradual;

(iii) flexibility to be in both directions, i.e. instil inter-play of two-way risks; and

(iv) make more use of existing trading-band from the yuan’s central parity rate.

In practice, the regime closely resembles a managed crawl. It is akin to the policy that let the yuan appreciate by some 21% against the US dollar until the financial panic hit in 2008.

Be that as it may, the expectation of a stronger yuan can only attract inflows of “hot money” betting on further yuan appreciation.

That is why the PBoC insisted that “it is not appropriate given China’s diversification of trade and investment that the yuan is fixed solely to one currency, as it won’t accurately reflect the real value of the yuan.”

Trading under the new regime

To forestall undue expectations, the PBoC’s weekend statement made clear that a big one-time revaluation was not on the cards.

Indeed, the band under which the yuan trades daily will not be widened beyond 0.5%.

In the short run, it’s wait-and-see how far and how fast the PBoC will allow the currency to appreciate.

On its first day of trading, the yuan rose to a new high against the US dollar, closing at 6.7976, up 0.42% from Friday’s (June 18) close of 6.8262.

It was the yuan’s strongest level since the currency was regularly traded.

The previous high was in July 2008, just before it was pegged to the US dollar at around 6.84 and kept there for the next two years to help stabilise its economy amid global recession.

To be sure, the yuan had since appreciated 3.8% so far this year on a trade weighted basis, thanks to a shrinking euro.

On its second day of trading, the yuan weakened, reflecting the PBoC’s message that the new regime doesn’t guarantee a one-way bet on its currency. It ended at 6.8136, down about 0.23% from Monday’s close.

Indeed, the markets got the message – two days of trading reinforced the PBoC’s goals to allow market trading to drive the exchange rate; and to move it up and down, mainly to deter speculation.

At this early stage, the PBoC is concerned – and rightly so – that the perception of yuan appreciation as a sure thing will trigger massive capital inflows (hot money) to the detriment of Beijing’s ability to maintain stability.

The PBoC’s most effective means of control has been setting daily the rate for the yuan (i.e. CPR or central parity rate) to start-off trading.

Given the yuan can only move 0.5% + CPR, overall yuan movement is not set by intra-day trades but by how the CPR moves from one day to the next.

This way, the PBoC seldom needs to intervene directly in the market.

On the second day of trading, the CPR was set at 6.7980 (almost where it closed on Monday), i.e. 0.42% stronger than Friday’s close. This fuelled expectation the PBoC won’t try to reverse Monday’s gains.

But early into trading, the yuan reversed and abruptly weakened, with heavy US dollar buying by banks at around 6.8000.

After a week of trading, the yuan closed stronger at 6.7922, up 0.5% from its close a week earlier.

By Wednesday (June 30), it closed up 0.65% at 6.7817. To be fair, when the PBoC said there would be no dramatic movements, it wasn’t kidding. But expectations are high.

President Obama anticipates the yuan is “…going to go up significantly.”

This expectation is being tempered by the IMF: “It will take time for the yuan to reach its normal market volume.”

Next developments will depend on the patience of the US if the evolving yuan revaluation proves all too gradual.

“Hot money”

The new regime has boosted Asian currency values. The South Korean won, Australia dollar, Thai baht and the ringgit felt the biggest impact.

Traders centred on these currencies, which they regard as proxies for China’s growth and its appetite for imports with a stronger yuan.

That in turn makes central banks in Thailand, Malaysia, Indonesia and South Korea feel more comfortable about letting their currencies strengthen.

It helps fight inflation because imported goods get cheaper, and reduces need to raise interest rates.

All over Asia, there is now greater tolerance for currency appreciation.

While attracting foreign capital is usually good, short-term inflows can cause bubbles in stocks and property. And, when they pull out at the first hint of trouble, panic usually takes over.

South Korea and Indonesia imposed new measures recently aimed at moderating their impact. China’s history of sharp and disruptive capital inflows during 2005-2008 offers an object lesson.

The yuan’s gradual strengthening (up 21% against US dollar from 2005-2008) coincided with huge gains in Asian stocks (Hang Seng China Enterprises Index traded in HK rose 319%). Hence, China’s concern over speculative risks complicating efforts to control money supply.

To deal with this, the PBoC promotes the idea the yuan-US dollar exchange rate is unpredictable, and can swing in both directions. Its management of the yuan in its first 10 days demonstrated this.

This should help mitigate hot money inflows.


China’s SAFE (State Administration of Foreign Exchange) which manages its US$2.5 trillion in foreign reserves, is concerned that hot-money investors are exploiting pricing differentials between domestic forward markets and offshore NDFs (non-deliverable forwards) market.

But unlike South Korea, which recently imposed restrictions to reduce won volatility, SAFE opted to continue to monitor instead.

NDFs are derivative contracts traded among foreign investors that pay-out based on expectations on the value of the yuan against US dollar in the future.

Following the flexibility, 12-month NDFs moved sharply on Monday to a 3% rise of the yuan in the next year (compared with 1.8% on the prior Friday); 6-month forwards are up 1.3%.

Economists offer four reasons in believing hot money flows will be limited:

(i) a 3% appreciation is too slim to attract investors unable to attract leverage;

(ii) fears the Chinese economy may “cool” and the bubble property market is about to burst;

(iii) expectations on asset prices have since “cooled-down” – Shanghai stock market is already down 30% this year and housing sales are dropping sharply; and

(iv) a possible global double-dip recession.

Internationalisation of the yuan

Concomitantly, the PBoC separately confirmed plans to expand its trial programme to settle trade deals in yuan.

It’s part of a broader effort to modernise and internationalise its currency.

First started in July 2009, it encouraged companies in Shanghai and Guangzhou province to use the yuan instead when trading with Hong Kong, Macau and some foreign countries.

After a slow start, Tuesday’s announcement expanded the programme to 20 of China’s 31 provinces and now, all foreign countries can participate.

To date, the value of such yuan-based deals totalled only US$6.5bil, or less than 1% of China’s total foreign trade.

The obstacle has been reluctance of many companies to hold the yuan because of its limited use outside China.

This has to do with China’s reluctance to make the yuan fully convertible, a policy Beijing intends to hang on to.

Increased yuan flexibility can make it more attractive to hold, provided it leads to appreciation.

This programme offers Chinese exporters a way out of worries on currency risks since their costs are mainly in yuan.

Euro’s recent volatility heightened this concern. Europe is China’s biggest trading partner.

Despite the calmness of yuan trading under the new regime, the currency dispute in China has not gone away.

But so far, reactions have been positive. At home, opposition to even a 3.5% appreciation of the yuan remains strong, especially within China’s export lobby.

The warning shot has come subtly: “Water doesn’t boil if it is heated at 99°C. But it will boil if it is heated by one more degree.”

Internationally, it’s just more wait-and-see. Expect the initial euphoria to dissipate quickly as politics and reality set in.

I am now reminded of former Chinese Prime Minister Zhou Enlai’s response when asked 175 years after the fact, what he made of the French revolution.

He thought for a moment and then answered: “It is too soon to tell.”

I end as I began. The yuan revaluation is not China’s most critical problem today.

China has to embark also on other reforms, including re-designing macroeconomic policies that don’t over-emphasise growth, privatising state-owned enterprises and liberalising financial development, striking a better balance in income distribution, and aggressively promoting services sector development.

Such a comprehensive rebalancing exercise can be made to work, but will necessarily take time. For now, it’s steady as she goes.

·Former banker Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome at
Watch out: yuan may fall as volatility picks up
By Lu Jianxin and Koh Gui Qing
An employee poses with Chinese yuan notes inside a bank in Taipei April 23, 2010. Now that China is staying true to its word and letting the yuan trade a bit more freely, analysts and investors outside the mainland may not be prepared for one potential outcome: a yuan drop.

SHANGHAI (Reuters) – Now that China is staying true to its word and letting the yuan trade a bit more freely, analysts and investors outside the mainland may not be prepared for one potential outcome: a yuan drop.

China is showing a determination to let the yuan be more volatile against the dollar within its daily 0.5 percent trading band and go with the market flow, contrary to some expectations for another steady rise as happened between 2005 and 2008.

That means there are no guarantees that the yuan will appreciate against the dollar over time, and Beijing is set to stick firmly to its position on yuan flexibility no matter how much it disappoints critics — most prominently U.S. lawmakers.

The fundamentals arguing for substantial yuan appreciation have changed since the financial crisis: China is running smaller trade surpluses, and economists see the potential for the shrinking current account surpluses to turn into deficits in coming years.

As a result, the basis for steady but slow yuan appreciation versus the dollar is not as strong as five years ago — one reason why Beijing keeps emphasising flexibility in its pushing forward the reform of its currency system.

“China’s new yuan policy lays emphasis on a quick response to changes in economic and market conditions, with no preset levels for yuan appreciation either in the short term or long term,” said Chen Lu, chief economist at Haitong Securities in Shanghai.

The People’s Bank of China has matched its words with deeds by allowing greater yuan volatility since the June 19 announcement and subsequent clarification that flexibility still means that yuan moves must be gradual and controllable.

The yuan has moved in an average daily range of more than 100 pips since its depegging, far above the 50 pips that dealers say would allow banks to engage in proprietary trading intraday.

This compared with a daily movement of only a few pips during the two years when the currency was pegged to the dollar.

Banks are just starting to do more day-to-day speculation, adding to liquidity in the local spot market.

Before the depegging, the limited daily swings meant all trading was almost a pure reflection of supply and demand, with the PBOC keeping the market in check.

Realised volatility in dollar/yuan has jumped as spot has started swinging more sharply within the daily trading band on the official CFETS platform.

For a graphic on dollar/yuan and realised vol, click r.reuters.com/vyv45m


The PBOC is apparently fostering two-way trade within the daily trading band for the spot yuan rate , trying to get banks and companies accustomed to greater volatility and to hedging currency risks.

But during the peak of speculation on yuan gains early last week, the PBOC used state banks to buy dollars in hefty chunks, effectively limiting the market’s ability to short dollar/yuan — especially since banks are not allowed to hold short positions overnight.

“Some big Chinese banks bought dollars in such large amounts that they could not have been acting on demand from clients or doing their own trading. They apparently did that on the PBOC’s behalf,” said a European bank dealer.

“Instead of being complacent about the latest yuan rise, investors may need to prepare for rainy days when the PBOC actually permits the yuan to depreciate against the dollar.”

Dealers said the state banks scooped up dollars at a wide variety of levels, suggesting the authorities were not trying to defend the yuan at a certain level.

These mechanisms are a step back from direct intervention by the PBOC in trading, often employed in the post-revaluation phase of yuan appreciation from 2005 to 2008 and during the de facto dollar peg of the past two years.

Dealers also believe the PBOC may have also adopted a new formula for setting the mid-point, or its reference rate, for the daily trading band.

It appears it sets the mid-point using the yuan’s close on the previous day plus overnight moves in the dollar index, making the mid-point market-oriented rather than an expression of the central bank’s desires as before.

But traders expect the PBOC to keep the mid-point as a ready weapon for the PBOC for limiting any yuan moves during times of market volatility. The PBOC consults with banks but keeps the market in the dark as to how it sets the rate.

During the peg, the PBOC tweaked the mid-point by only one or two pips each day. Any trades happened far from the reference rate on a given day would have to be covered around the mid-point in subsequent days, discouraging moves far from the mid-point.

Since the depegging, the yuan has risen as much as 0.83 percent as the PBOC tolerated a rise to a post-revaluation high of 6.7700 against the dollar on Friday.

While the new regime has still disappointed critics in the United States, Chinese market players believe that Beijing will not make any further concessions and that new pressure from U.S. lawmakers — some of whom believe the yuan is undervalued by as much as 40 percent — would likely backfire.

The euro zone debt woes have cast doubt on the pace of China’s recovery, the latest reminder how vulnerable the world’s third-largest economy is to a global slowdown.

China’s still low per person income also argues against sharp yuan appreciation, economists say, arguing that it is inappropriate to apply Western standards to the currency of a country whose GDP per person was only 8 percent of that of the United States last year.

“What China can do is to show that it’s friendly, it’s cooperative and it’s willing to change in line with economic and market conditions,” said a senior Chinese bank dealer in Beijing. “As China will adjust the yuan’s value on a floating basis, yuan appreciation forecasts will become more or less a guessing game.”

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