The Growing Pains of the Chinese Yuan

The recent volatility of the yuan does not herald its weakening, but the increasing opening of the currency and still another milestone in its international ascent.

After a sharp depreciation of the renminbi since the beginning of 2014, the US, in early April, warned Beijing not to manipulate its currency, ahead of IMF, World Bank and G20 meetings in Washington.

In turn, IMF Managing Director Christine Lagarde warned of a risk of a “hard landing” in China, which led to a prickly debate with China’s Vice Finance Minister Zhu Guangyao. After these meetings, US Treasury slammed Beijing even harder on currency.

Ironically, as Beijing has initiated the most extensive and deepest reforms in three decades, it finds itself penalized, not rewarded in the West.

In reality, the yuan’s volatility did not come out of the blue. But nor was it the result of simple market forces. In part, it was engineered in Beijing – but as an integral part of the reforms, not against these reforms.

China’s central bank steers its course

In the past two decades, the euro and, to a lesser degree, the Japanese yen have become important regionally. However, neither has been able to challenge the U.S. dollar’s dominance globally.

Although the Chinese yuan is positioned to become a major reserve currency, that requires capital account convertibility, which is vital in international trade and finance. Furthermore, in the past quarter, international observers have expressed concern over the “weakening” of Chinese yuan, “currency wars” in Asia and trade conflict with America.

The realities are a bit different, however.

Ever since Washington stumbled into its debt crisis in August 2011, China has felt increasing unease with the symbiotic relationship that prevails between the Chinese yuan and the U.S. dollar.

When Washington was swept by still another debt crisis and government shutdown last October, Chinese concerns increased accordingly, due to Beijing’s stakes in US debt and dollar-denominated assets and reserves. China’s foreign exchange reserves alone had soared to $3.7 trillion.

A month later – after the Party’s Third Plenum, which codified the huge reform agenda of China’s new leadership – the priorities shifted at the State Administration of Foreign Exchange (SAFE). Led by PBoC’s deputy governor Yi Gang, SAFE’s new priority was to curb the growth of foreign reserves and make those reserves work more efficiently as investments.

That’s when Beijing’s focus shifted from the appreciation of the yuan toward building a market-driven rate-adjustment system that is flexible and requires less central bank intervention.

That’s also when China’s holdings of U.S. Treasury Securities began to decrease.

“Hot money” – the second round

Between 2010 through 2013 – at the peak of rounds of quantitative easing in the US, which encouraged massive amounts of foreign capital into China and other emerging markets – the Chinese yuan per US dollar decreased from 6.80 to less than 6.10. In mid-February came the currency’s six-day losing streak, which reflected the fastest yuan correction in two decades.

As major markets were swept by the so-called emerging market turmoil, China’s January report on international payments and transactions showed the largest historical ($73 billion) monthly dollar selling in the onshore market. As hot money was fleeing from vulnerable emerging markets, massive capital inflows were washing over mainland China.

China’s central bank was already weary with further foreign-exchange reserve accumulation. The PBoC wanted to defuse the role of the speculators. The yuan seemed a one-way-bet; a currency that would only appreciate.

So in mid-January (when US dollar was 6.04 Chinese yuan), the PBoC began to set weaker fixings, which undermined the assumption of ever-continuing appreciation (currently the yuan remains at 6.23). In turn, the PBoC intervened more to set the stage for the correction of the yuan. As analysts noted, these measures were compounded by weak seasonal data, rising financial pressures and investors selling their yuans in offshore markets.

Then came March 15, when the PBoC widened the daily trading band for US dollar and Chinese yuan, doubling it to +/-2% – another milestone in Beijing’s quest for capital account convertibility.

The lessons

The old era of central bank intervention, lower volatility and exclusively appreciating yuan is now fading out. In the new era, the PBoC’s interventions are decreasing, and the yuan can move more freely. While the fundamental trend is toward gradual appreciation, increasing volatility comes with the new territory.

As Beijing took another step closer to the yuan’s internationalization and its ultimate role as a major multipolar reserve currency, it has diversified risk and boosted capital efficiency. Meanwhile, its foreign exchange reserves have grown to $3.95 trillion, according to most recent data.

China’s role among the major foreign holders of US Treasury Securities peaked at $1.32 trillion in November 2013, when the priorities were re-defined at SAFE. It declined to $1.27 trillion by February 2014.

Today, one US dollar buys 6.21 Chinese yuan, but by the end of the year, the ratio is more likely to be around 6.00 to 6.05 yuan.

Reportedly, some 40 central banks have already invested in the yuan and others are following in the footprints. The launch of direct share-dealing between Shanghai and Hong Kong within six months is still another milestone in the same dynamic process.

Intriguingly, the Chinese currency is seemingly on its way to reserve status, even before full convertibility. In part, that reflects the yuan’s increasing attractiveness. In part, it heralds the growing unease with the US dollar.

After World War II, America was the world’s greatest creditor accounting for almost half of the world economy. Today, it is the world’s greatest debtor, accounting about the fifth of the global economy. And yet, U.S. dollar remains the primary world currency. In the long run, that’s not just an “exorbitant privilege,” but unsustainable.

Although the U.S. dollar still accounts for a third of global foreign exchange holdings, that ratio has been declining since 2000 (when it was 55 percent), according to the IMF. Meanwhile, the emerging markets’ share of reserves in “other currencies” has increased by almost 400 percent since 2003.

The lesson to investors? Do not mistake short-term fluctuations (here: the yuan’s recent volatility) with long-term structural trends (the economic rise of China and the long-term appreciation of the yuan).

We are not witnessing the ultimate end or triumph of the Chinese currency. The volatility of the past quarter heralds the growing pains of the yuan.

The original version was published by South China Morning Post on April 28, 2014