China’s Fighting the Wrong Battle for the Yuan
(Bloomberg Opinion) -- As the U.S. dollar hits highs for the year, the People’s Bank of China seems determined to hold the value of the yuan at seven to one, or stronger. This barrier holds little technical significance, but its psychological value and the central bank’s interest in holding the line are enormous.
While it’s difficult to confirm, there’s strong evidence that the PBOC is managing prices in the foreign-exchange market. Renminbi forward rates are essentially unchanged from spot rates extending out as far as three months. Amazingly, from three months to almost two years, implied forward rates suggest yuan strengthening. As China’s currency has been weakening steadily in the past few months, the forwards markets is announcing that the bottom has been reached and strength will follow.
This futures pricing would be implausible in a normal currency market because of the narrowness of the spread over time. As we become less certain about the future, time is the great risk in derivatives, so prices tend to disperse the further out we look. Longer-duration U.S. dollar forwards against the euro and the pound imply movements over time of as much as 10 percent, for example. The yuan futures market, on the other hand, is flat extending out three years, effectively indicating the currency has found perfect equilibrium.
As traders push the renminbi lower, they’ve met stiff resistance from the PBOC. Since July 1, the market has consistently weakened from the central bank’s fix by almost 0.01 yuan a day. In the first six months of the year, by contrast – even as the currency fluctuated – the average difference between daily market movements and the official fix was about one-tenth the size of the gap more recently. This implies the central bank fix was much more in line with market expectations.
What makes this a psychological battle with the PBOC’s demons is that the currency has remained closely correlated with the basket that sets its value. While the central bank says it lets the market determine the yuan’s price, it’s really other currencies, through the basket, that do so. As the dollar appreciates, we should expect downward pressure on the renminbi, and that’s what we’re seeing.
But psychological impact differs from technical reality: Seven is seen as a key metric for confidence in China. While the currency touched similar levels in December 2016, the last time it weakened from 7 yuan was shortly before the 2008 global financial crisis.
An appreciating currency is seen in Beijing less as the price of an asset and more as a barometer of the nation’s rise on the world stage. An ascendant China shouldn’t suffer from currency weakness, even if that weakness stems from the official design of the basket to which it’s pegged.
In fact, there’s little cause for concern. China’s external debt has risen a bit more rapidly in the past couple of years, but it remains low in both absolute and relative terms. The yuan has weakened against the dollar in line with many other currencies, especially those of emerging markets. The PBOC is fighting a pointless battle against this tide, as the Federal Reserve tightens liquidity and raises interest rates.
Central bank efforts to move prices have a poor track record everywhere. If China wants to increase market influence, it should signal a willingness to let the yuan track the currency basket, even if that means weakening in the face of dollar strength.
Instead of straining to keep the currency above seven, the central bank should be signaling that it wants market mechanics to work.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Christopher Balding is a former associate professor of business and economics at the HSBC Business School in Shenzhen and author of "Sovereign Wealth Funds: The New Intersection of Money and Power."
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