Yesterday, China’s yuan plunged to a 10-year low against the US dollar, almost on the verge of breaking the politically delicate level of seven to the greenback. The yuan declined to 6.9644 per dollar at noon, below its latest low recorded in 2016, before improving slightly.
Implications of Weak yuan on China’s economy & relationship with the US
The yuan, also referred to as the renminbi, or “people’s money,” has fallen by nearly 10% percent against the greenback since April as China’s economy cooled, while the US and Chinese interest rates went in opposite directions. The scenario assists exporters to manage the tariffs of up to 25% slapped by the White House on billions of dollars’ worth of Chinese goods.
The yuan’s weakness is one of the factors that fueled Washington’s list of complaints against Beijing. The US Treasury Department refrained from labeling China a currency manipulator but cautioned it is closely watching Beijing. On October the 17th, a dated Treasury report pointed out that China did not meet the requisite criteria to be stamped as a currency manipulator, a reputation that can trigger sanctions. The report, however, said Beijing along with Japan and Germany is on the list of governments whose exchange rate policies are being closely monitored.
Chinese authorities have guaranteed not to resort to “competitive devaluation” to increase exports in the midst of a tariff war with President Trump over Beijing’s high technology policy. Beijing is doing its best to make the state-controlled exchange rate reflect the opinion of market forces, which are pushing the yuan lower. Even though an exchange rate of seven yuan to the dollar has no economic significance, it could once again draw the US attention to the exchange rate.
Commenting on the yuan’s weakness, Mizuho Bank said Chinese authorities would probably “stand their ground” and avoid a “capitulation beyond the 7 level.”
Similarly, Larry Hu, chief China economist at Macquarie in Hong Kong, said: “For currency flexibility, it’s not absolutely unacceptable for the RMB to go beyond 7, especially when the dollar strengthens like now.”
However, Joachim Fels, a global economic adviser at Pacific Investment Management Co, believes that the yuan may cross above 7. While giving an interview in Hong Kong, Fels said: “If there is market pressure for the currency to go beyond 7, they will probably allow it to happen. There is still the risk of accelerated capital outflows, which is why the central bank wants to at least smooth the currency depreciation.”
A weaker yuan could also promote the outflow of capital from China. That would increase the cost of borrowing at a time when the domestic industries are facing a slowdown. The People’s Bank of China has tried to make its exchange rate discovery mechanism more efficient by strengthening the role played by market forces.
The exchange rate is fixed every morning and may fluctuate by 2% against the dollar during the day. The central bank can buy or sell foreign exchange, or instruct Chinese commercial banks to do so, to minimize volatility. Some think tanks believe that Beijing’s approach could undergo a drastic change if Trump and his Chinese counterpart, Xi Jinping, do not make progress at a possible meeting during the gathering of G20 nations in November.
The central bank has attempted to discourage speculation by implementing a new requirement in August that calls for traders to make deposits for contracts to trade yuan. This enables the continuation of trading, but increases costs. Last Friday, PBoC Deputy Governor Pan Gongsheng said that the Central Bank would undertake macro-prudential measures to stabilize expectations in the Forex market and that it is certain that the yuan will stay fundamentally stable at a reasonable level.
At a news conference in Beijing, Pan Gongsheng, deputy governor of the People’s Bank of China, said: “For those who are trying to short the renminbi, we fought hand to hand a few years ago, so we are very familiar with each other. I think it’s still fresh in our memory.”
Beijing introduced similar restrictions in October of 2015 after an overhaul in the exchange rate identification process enabled markets to speculate that the yuan would slump. The currency stabilized briefly but tumbled the following year. China is clamping down on its citizens who circumvent the country’s stringent capital controls to move funds out of the country to buy residential real estate abroad, which analysts say will further moderate requirement in the Australian market.
The investors illegally collected the quotas, which belonged to a large number of individuals, in order to get enough capital from the country to buy real estate, or to channel money through so-called “underground banks.”
Commenting on the Chinese government’s move to curb the illegal outflow of money, Zong Liang, a senior researcher with the Bank of China, said: “The Chinese government doesn’t encourage this irrational overseas investment. Overseas property investment will be more rational in the future. There could be an impact on the Australian property market due to shrinking demand from China.”
The government has also started publishing the cases of individuals, who were caught trying to siphon money through the back door. It is done with the belief that the millions of dollars paid as fines will serve as a warning to others who are attempting such misadventures.
The offshore yuan’s three-month risk reversal, a measure of traders’ bearish view of the currency in the options market, has peaked to the highest level since January 2017. This suggests that the demand for bets on the further decline of the yuan is rising.
Last month, according to data released by the Monetary Authority, Chinese banks sold the most foreign exchange to customers since 2016. The figures tally with the central bank’s disclosure about the most significant decline in foreign exchange purchases since January 2017, due to greater interventions.
In addition, the nominal value of the new options betting on the yuan will decline beyond $7 has increased to USD 62 billion, three times the level reported in September, per Bloomberg calculations based on data from Depository Trust. Option prices show that the probability of the yuan reaching 7 in the next quarter has almost doubled in the last three months to 43%.
The yield spread between ten-year government bonds from China and the US fell last week to 37 basis points, the lowest level since April 2011. That makes onshore bonds and other assets, which are yuan-denominated, less attractive, thereby reducing capital inflows. All the factors discussed above indicate that the yuan will remain bearish in the short-term.
Disclaimer: Any financial trading analysis offered here is our opinion and is not intended as advice or direction for investors. We cannot guarantee the success of any trades made as a consequence of this article, and we encourage traders to incorporate a strong money management strategy to limit losses when they enter the markets. Please use this article as part of your own research before formulating strategies prior to trading.
