The curious case of China's falling yuan

A 100-yuan banknote against the background of a US dollar sign Image copyright Getty Images
Image caption China's central bank is probably reminding traders that the yuan is not a one-way bet

The Chinese currency has had its biggest one-day fall, down nearly 1%, and has fallen 1.5% for the past week and a half. It is the biggest decline since 2005 when it introduced its new currency regime and moved away from a tight peg against the US dollar.

Dropping to 6.1 yuan to the dollar, the currency has broken a long-term trend of appreciation. Recall that it had been around 8 yuan to the dollar in 1994 when the exchange rate was set up.

The Chinese central bank, the People's Bank of China (PBOC), is right in that these are not big moves in the foreign exchange market. In a statement, the PBOC says this volatility is normal for other economies so there's "no need to over-interpret it."

But since the Chinese currency is controlled by the central bank to move within a narrow band of 1% around a daily fix and isn't convertible, the breaking of a steady trend will be viewed as a signal.

So what is the central bank signalling? Probably that the yuan isn't a one-way bet, meaning that the currency can fall as well as rise. It matters in that if traders expect the currency to always rise, then they will increase demand for the yuan that produces the intended effect.

As China wants to control the pace of appreciation, it ends up having to intervene to buy dollars and there's not a huge appetite to buy even more dollars as China holds rather a lot already.

Long-run value

There's also appreciation pressure from the demand for yuan as capital continues to flow into China, despite slowing growth, or perhaps because of it, since investors seem to like steadier and more balanced growth.

By demonstrating, or rather orchestrating, that the currency can fall as well as rise, the central bank is trying to show the currency isn't a one-way bet, since that can be self-fulfilling.

The central bank may also see the yuan as being close to its equilibrium value, so there shouldn't be too much upward pressure or the currency could end up being over-valued and that would hurt exports.

Of course, it's not possible to say what the long-run value is due to a number of reasons; China has no market-clearing interest rate (it has several benchmark lending and deposit rates), the currency isn't tradable across China's borders, and inflation isn't well-measured.

So it's difficult to make what economists call purchasing power parity (PPP) estimations, that essentially says that goods should eventually cost the same across countries, so exchange rates offset pricing differences. Well, that's hard to work out for most countries which is why the short-run exchange rate can be volatile.

Reading the tea leaves, a bit of volatility is probably what the Chinese central bank is after. The internationalisation of the yuan is underway where the Chinese currency is now traded in offshore hubs such as London.

According to the global transaction services organisation, SWIFT, the yuan is already the seventh most-traded currency in the world, after the highly liquid top six currencies, rising quickly in just a couple of years. And this is without it being tradable or convertible.

So the exchange rate reforms are gaining speed. The PBOC has a plan to allow the currency to be liberalised within the decade, and the Shanghai free trade zone is experimenting with allowing the yuan to be traded.

Steady rise

For these reforms to work, they wouldn't want speculators to push up the value of the currency, so the PBOC is flexing its muscles to show that it is in control and what it wants is for the currency to move up as well as down.

It is hard to bet against a central bank - whether it's the Chinese or the Swiss. But for now, most economists still expect that the yuan will continue its steady rise as the economy continues to grow.

The PBOC could find that it is working against the fundamentals of the economy so it probably won't try and depreciate the currency by much, but it is well able to intervene and make it move up and down on a daily basis.

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