China’s yuan market spurs FX volatility

After two years of promoting greater international use of the yuan, China has a currency - like it or not — that is influenced more than ever by the fickleness of global markets. When the yuan exchange rate hit limit-down for 10 straight days in early December, many analysts saw evidence that “hot money” was fleeing China amid fears of a hard landing in the world’s second-largest economy. But beyond the short-term panic, the yuan’s brush with depreciation exposed how reforms intended to promote yuan trade settlement have created new ways for firms involved in trade to skirt the country’s strict capital controls. This has exposed the onshore forex market to more dramatic ebbs and flows. “The episode may have signaled a permanent change in the pattern of the exchange rate’s movement,” Yu Yongding, a former member of the People’s Bank of China’s (PBOC) monetary policy committee, wrote in a recent op-ed on Project Syndicate, a website for commentary on global economics and finance. Speculators can’t easily “short China”, thanks to capital controls that create major obstacles. Still, trading firms can piggyback on pessimism because of how policy changes have affected foreign-exchange flows and the exchange-rate. In particular, the rise of the offshore yuan (CNH) market in Hong Kong has enabled corporations involved in trade, which are allowed to move money into and out of mainland China more easily, to arbitrage the spread between the onshore and offshore yuan exchange rates. The result is that China’s forex flows have become more volatile, as capital controls are less able to blunt the effect of international forces. The buildup of forex reserves is now an increasingly imperfect gauge of demand for Chinese goods and services, as well as foreign investment in China’s economy. More than before, data can be misinterpreted. Dollars once sold to China’s central bank may now be sold into the offshore market, reducing forex buildup, even when demand for yuan remains high. Alternatively, dollars once bought from the central bank in exchange for yuan may now be bought offshore, adding to net forex accumulationshore, even if overall demand for yuan is steady or decreasing. OPPORTUNISTIC HEDGING The increased volatility will also create additional pressure on the PBOC to further loosen its grip on China’s exchange rate by widening the yuan’s daily trading band, since a wider band would require fewer and less significant market interventions to maintain. For most of the period since CNH began trading actively in late 2010, offshore yuan has traded at a premium to the onshore spot rate. For Chinese importers, who are net dollar buyers, this premium created an incentive to shift their dollar purchases offshore, where the same amount of yuan bought more dollars. The effect of this offshore premium most likely supported China’s buildup of forex reserves for the first three quarters of last year. China’s reserves grew by $270 billion in that period, 16 per cent greater than the same period in 2010, despite the fact that China’s trade surplus during that period contracted from 2010. While possible shifts in mark-to-market valuations of China’s reserves make any such calculation imprecise, that suggests that other factors, such as the rise in offshore dollar purchases by corporates, may have been partly behind the unexplained rise in reserves. But in September last year, the offshore rate swung to a discount, as heightened concerns about Europe’s debt crisis and slowing global growth led to a flight to safety. The emergence of a CNH discount reversed the incentives. Now it was exporters — who sell dollars received from foreign customers in order to pay costs in their home currency — who faced an incentive to shift their transactions offshore. With fewer exporters selling dollars to the PBOC onshore, that contributed to China’s foreign exchange reserves decreasing by $21 billion in the fourth quarter, the first quarterly decline since China began publishing monthly figures in 1999.