Reasons Not To Be Alarmed By A Tumbling Yuan

Zhong Zhengsheng | The yuan has depreciated further against the U.S. dollar recently, with the central parity rate on July 6 hitting the lowest level since November 2010, at 6.68 yuan for every dollar. On the same day, the China Foreign Exchange Trade System run by the central bank announced that, starting from August 15, all foreign banks must set aside interest-free reserves equal to 20 percent of their forex forward position when they tap China’s onshore market to offset trades they conducted overseas.

Investors are faced with two important questions: Why has the yuan’s value kept falling relative to the U.S. dollar, and will the new yuan exchange rate system hold under pressure?

Regarding the first question, the yuan’s central parity rate against the dollar has weakened by a total of 545 basis points from July 4 to 6. But in this week to date, the U.S. Dollar Index has gone up by only 0.62 percentage points.

The contrast could be explained by the logic of a “strategic devaluation” that we think the central bank has pursued, since it indicates the bank needs to control the pace of the yuan’s weakening against a basket of currencies, not just the U.S. dollar.

The problem, however, is that the yuan’s value against the dollar has already hit very low levels, and if the same happens with the basket of currencies, investors’ anticipation of the yuan continuing to depreciate will be greatly reinforced.

This puts the central bank in a tough spot. It has promised to adhere to the new rules of calculating the yuan’s central parity rate, which link it to the currency’s closing price on the previous day in the onshore foreign exchange market. Judging by recent data, it has indeed kept the promise. But keeping the promise also means it will have to allow the yuan to continue to devaluate against the U.S. dollar, because that’s what the supply and demand conditions in the market indicate will happen.

In a sense, the central bank has made an unwilling choice to let the yuan face increasing devaluation pressures, because it wants to keep the new rules for central parity rate. But there is a risk that it may one day lose control of the situation. So how far is the government willing to push the limit, before it may have to backtrack on the new rules?

That’s a question to which all investors would like to know the answer.

In my view, there is no need to worry too much about the yuan’s exchange rate for the rest of the year. The reasons are two-folded.

First, the U.S. Dollar Index has limited room for growing further this year. Before the Brexit vote, the U.S. dollar strengthened mainly on expectations that the Federal Reserve would raise interest rates. But the current prices of the Federal Funds Futures show that investors now think there will be no interest hike this year. The dollar is still strengthening, mainly because the pound’s value has fallen and the sentiment of risk aversion has intensified. This is like what happened when Britain exited the European Exchange Rate Mechanism in 1992. The values of the British pound and the European Currency Unit fell after the exit, while the U.S. Dollar Index surged.

However, it’s unlikely the U.S. Dollar Index will surpass 100 this time.

This is because the conditions of the American and the global economies do not support a much stronger dollar. Since late 2014, when the dollar started picking up in value, oil prices have plunged and emerging economies have been affected. The European Union and Japan are ratcheting up their quantitative easing monetary policy. These are all signs that the global economy has remained weak.

Historical data also suggest that the index may peak at around the 100 point mark this time. In 2001 it peaked at 120, down from the 160 level in 1985. On both occasions, however, the American GDP was growing at a much faster rate and interest rates were high.

In addition, the pound’s depreciation following the Brexit vote, which has driven to a large extent the recent increase in the dollar’s value, will not continue. In fact, the amount of short positions placed on the British currency has shrunk a lot over the past few days, reflecting a gradual return of investor confidence as uncertainties reduce.

Second, the Chinese central bank wants to keep the yuan’s exchange rate stable and has the ability to do so. If necessary, it may temporarily put the new rules aside and peg the yuan more to the U.S. dollar than a basket of currencies.

There is no doubt that the central bank does not want the yuan’s exchange rate to repeat a sharp devaluation that happened after it changed the rules for deciding the central parity rate last August. This is because a series of high-profile political and economic events are scheduled to take place soon, including the G-20 summit in Hangzhou in September, the inclusion of the yuan into the International Monetary Fund’s Special Drawing Rights in October and the U.S. presidential election in November.

The central bank also has the ability to stabilize the yuan’s exchange rate. It has drained liquidity from the offshore market and drafted rules for imposing a “Tobin tax,” on cross-border currency transactions to curb speculation. With foreign exchange swaps, it can also intervene in the forex market without tapping the country’s forex reserves.

In addition, Chinese companies are under less pressure to repay foreign exchange loans, as indicated by data from the State Administration of Foreign Exchange for the first quarter.

Taken together, if the U.S. dollar continues to strengthen significantly, it is possible that the Chinese central bank may backtrack on the progress it made on the yuan’s exchange rate system, so the central parity rate will depend more on the value of the U.S. dollar than that of a basket of currencies. But this will be temporary, and when conditions allow, it will switch back to emphasizing a basket of currencies over the U.S. dollar.