China's Yuan Woes Get Worse
In the first week of 2017, the offshore yuan surged by a record amount against the U.S. dollar over two days, interbank borrowing costs soared and volatility intensified. The following week, pretty much everything reversed. It's a familiar pattern that exemplifies the contradictions bedeviling China's currency.
Policy makers have expended much effort trying to internationalize the yuan, notably by pushing the International Monetary Fund to include it in its Special Drawing Rights basket. They also want to control the yuan's value, fearing that a freely floating currency would destabilize the financial system.
These goals are in obvious tension. But the government's efforts to resolve that tension are only causing more distortions, as investors and companies find ways to game the system. This month's gyrations are a case in point.
As with monetary policy, the name of the game in foreign exchange is expectations. If Chinese investors expect the yuan will depreciate against the dollar, they'll try to move their money out of the country. With economic growth sluggish, financial bubbles proliferating and few domestic investment opportunities, that's a sensible expectation.
The People's Bank of China is in the awkward position of trying to alter that expectation. Since Aug. 11, when the central bank surprised the world with a devaluation of 3 percent, it has been trying to steer the yuan lower without letting investors make a one-way bet. Its solution has been to engineer periodic liquidity crunches. The yuan lending rate in Hong Kong has repeatedly spiked, even reaching 200 percent a year ago.
These crunches pushed the yuan higher, raised borrowing costs and imposed some losses on investors. But they did nothing to reset expectations about the yuan's long-run trend. As of November, yuan deposits in Hong Kong had shrunk almost 40 percent from their peak in December 2014, declining by an average of 3 percent a month since August 2015.
After all the turmoil earlier this month, the onshore yuan -- which is more tightly controlled by the PBOC and state-owned banks -- remains essentially unchanged. The two rates are drifting back toward parity, signaling an end to the transient surge. Once again, the PBOC has been unable to reset expectations.
By now, investors have caught on to this pattern. Almost as fast as the offshore yuan and interest rates surge, they fall back to a long-run trend and the yuan resumes its slow and steady decline. Because hedge funds and other investors use sophisticated strategies to guard against these fluctuations, the liquidity crunches are no longer imposing significant losses on them. That means they can quickly resume short-selling the yuan.
Arbitrage opportunities have also arisen. When the yuan trades at a premium onshore, for instance, state-owned companies can instruct an offshore subsidiary to import products from the onshore parent, paid for in yuan. The parent company converts the yuan into dollars at the preferential onshore rate, then uses those dollars to import another product from the subsidiary. This trade is one reason for the large statistical discrepancies between China and its key trading partners.
Capital controls, the other main way the government is trying to manage the yuan, are causing similar distortions. Chinese companies have proved amazingly adept at using the more liberal current account to disguise capital outflows. Some are selling yuan-denominated wealth-management products to fund overseas acquisitions using special-purpose vehicles. This gives an investor partial ownership of a foreign asset and thus passes on expected depreciation gains. The company takes the money out of China, but the investor receives the benefit of international diversification. Expect more of this kind of thing.
China is left with a shrinking range of options. It could engage in a prolonged tightening of the offshore yuan. But that would require a months-long effort to reduce liquidity and raise interest rates, which would pose serious risks for indebted Chinese companies and lead to more distortions and gamesmanship. It would also end hopes of the yuan being a major international currency any time soon.
Another option is to crack down further on yuan outflows. But a raft of such measures over the past year has had little effect. Regulators would have to consider more radical options, such as enhanced restrictions on current-account transactions, which they so far have been loath to pursue. Doing so could cause widespread economic dislocations -- and might not work.
With its current strategy, the government is trying to split the difference. Yet with more yuan leaving the country, and foreign-exchange reserves dwindling, the clock is ticking. China has to decide what is more important: an international currency, which will require greater capital mobility and relatively free price determination, or control over the yuan's value, which will require increasingly draconian restrictions.
It can't have both.
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