On March 15, 2014, the People’s Bank of China announced that it would widen its trading band for the Chinese yuan to 2% from 1%. While rhetoric about widening the trading band had increased in recent weeks, most analysts believed this change in policy would occur later in the year. After appreciating by nearly 3% in 2013,1 recent losses in the Chinese yuan have given some investors pause.
Could this be a symptom of an impending “hard landing”? In our view, this most recent period of volatility is not connected to potential economic troubles in China, but rather a deliberate move by policy makers to rattle speculators before announcing a change in policy. Similar to the last widening in 2012, the yuan could drift or become slightly weaker in the near-term as investors mull the heightened impact of greater currency volatility. Ultimately, we remain confident that the Chinese yuan can appreciate against the U.S. dollar by the end of 2014.
While 2013 was a volatile year for most emerging market currencies, we noted that the Chinese yuan quietly appreciated by nearly 3%. However, in early 2014 this differentiation in performance proved short-lived. In the final two weeks of February, the Chinese yuan depreciated against the U.S. dollar by over 1.3%. Next, during a 2 week period in mid-March, the currency depreciated by over 1.7%. For a currency with a historical volatility of only 2%, these dramatic moves (by comparison) caught many China watchers flat-footed. Up until this point, the consensus view was that China would be widening its currency band sometime in 2014, and that policy would eventually inject more “two-way volatility”2 into the market.
Recent Market Volatility
The best way to describe Chinese policy makers’ recent guiding of a decline in the value of the yuan is “a shot across the bow.” The principal reason why Chinese policy makers have historically rejected pressure to allow the yuan to float freely and permit conversion on the capital account is the potentially destabilizing effect of “hot money.” As money pours into an economy, the currency strengthens, but the country also becomes awash in excess liquidity and exports become more expensive by comparison.
For a strongly export-oriented economy such as China, an excessively strong currency can have a significant impact on economic growth. This was precisely what many emerging market central banks complained about in early 2010, when the value of their currencies rose sharply against the dollar as the U.S. sought to lower interest rates via quantitative easing. Given the potential for the destabilizing effect of “hot money,” China has imposed certain restrictions in order to protect its economy and, by extension, keep domestic constituents contented.
To affect this policy, China has historically permitted its currency to fluctuate by a predetermined percentage per day (now 2%) and placed caps on the amount of yuan that can flow from markets outside of China into the mainland. Although this recent depreciation in the yuan has been unsettling, China may have achieved the intended goal of causing pain for leveraged speculators in its currency market and injected some doubt into the one-way appreciation bets. While the future path of China’s currency is still far from certain, it is worth noting that the Chinese yuan has yet to depreciate against the U.S. dollar in a calendar year since it began to float back in 2005.
Yuan Depth and Liquidity Increasing
To put these most recent moves in context, this most recent sell-off in the Chinese yuan represents one of the sharpest reversals since September 2011. At that time, analysts explained that the sudden drop was particularly violent due to a lack of liquidity in the CNH market3. Fast-forward to the end of 2013, the offshore yuan market has doubled in size in terms of assets over the past year.4 Additionally, we noted in a previous blog post, liquidity and trading volume have been increasing steadily, offshore centers are cropping up in Singapore, Taiwan, London and now potentially Korea, and the amount of global trade being invoiced and settled in yuan is continuing to rise.