Birth pains for the yuan as a global currency
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For the financial industry in China and Hong Kong it was a dramatic start to the New Year.
The yuan fell sharply, continuing a selling trend, which began at the end of 2015. Volatility was extreme and a large gap opened up in the spread between the offshore (CNY) and onshore (CNH) rates, which in turn pushed up overnight interest rates to 66 percent at one stage.
The big sell-off in the yuan also fuelled concerns about China’s economy that affected equity markets, starting with a sell-off on the Shanghai market. However, the Chinese currency stabilised at the end of last week after Chinese banks bought yuan and sold dollars.
Although some blamed the weakening Chinese economy for the drama, this seems to be exaggerated, as there were no real surprises in recent economic news. Export volume in December was actually better than the market expected.
In my view it was caused by other factors, namely the de-pegging of the yuan to the dollar and the inclusion of the yuan as a reserve currency by the International Monetary Fund.
For two decades the yuan has closely tracked the US dollar. In recent years, this has had a negative effect on the Chinese economy, as the rapidly appreciating greenback has also pushed up the Chinese currency, making Chinese exports less competitive.
At the end of last year the People’s Bank of China announced its intention to manage the yuan against a basket of currencies which will weaken the yuan against the dollar and effectively be the end of the dollar peg.
Meanwhile, in October the yuan will become a reserve currency, as it will be added to the IMF’s SDR (Special Drawing Rights) basket, which can be used as official reserves by central banks. To meet the requirements of the IMF, the yuan needs to be more open to market forces.
Given that it is considered to be over-valued by around 15 per cent, this encouraged market players to test the new freedom by shorting the yuan. However, the intervention of the central bank dried up liquidity in the market and pushed up interest rates so speculators were badly burnt.
Since the central bank is expected to step in again if volatility becomes extreme, or there is a threat of disorderly capital flight, this should discourage similar speculation, at least for now.
Times of change are always difficult and it seems that the yuan is experiencing birth pains as it makes the transition to a global currency. Hopefully from now on the yuan’s path towards a new level will be an orderly one and this will be reassuring for those doing business with China.
