The Chinese currency has had its biggest one-day fall, down nearly 1%, and has fallen 1.5% for the past week and a half. It is the biggest decline since 2005 when it introduced its new currency regime and moved away from a tight peg against the US dollar.
Dropping to 6.1 yuan to the dollar, the currency has broken a long-term trend of appreciation. Recall that it had been around 8 yuan to the dollar in 1994 when the exchange rate was set up.
The Chinese central bank, the People’s Bank of China (PBOC), is right in that these are not big moves in the foreign exchange market. In a statement, the PBOC says this volatility is normal for other economies so there’s “no need to over-interpret it.”
But since the Chinese currency is controlled by the central bank to move within a narrow band of 1% around a daily fix and isn’t convertible, the breaking of a steady trend will be viewed as a signal.
So what is the central bank signalling? Probably that the yuan isn’t a one-way bet, meaning that the currency can fall as well as rise. It matters in that if traders expect the currency to always rise, then they will increase demand for the yuan that produces the intended effect.
As China wants to control the pace of appreciation, it ends up having to intervene to buy dollars and there’s not a huge appetite to buy even more dollars as China holds rather a lot already.
There’s also appreciation pressure from the demand for yuan as capital continues to flow into China, despite slowing growth, or perhaps because of it, since investors seem to like steadier and more balanced growth.
By demonstrating, or rather orchestrating, that the currency can fall as well as rise, the central bank is trying to show the currency isn’t a one-way bet, since that can be self-fulfilling.
The central bank may also see the yuan as being close to its equilibrium value, so there shouldn’t be too much upward pressure or the currency could end up being over-valued and that would hurt exports.
Of course, it’s not possible to say what the long-run value is due to a number of reasons; China has no market-clearing interest rate (it has several benchmark lending and deposit rates), the currency isn’t tradable across China’s borders, and inflation isn’t well-measured.
So it’s difficult to make what economists call purchasing power parity (PPP) estimations, that essentially says that goods should eventually cost the same across countries, so exchange rates offset pricing differences. Well, that’s hard to work out for most countries which is why the short-run exchange rate can be volatile.
Reading the tea leaves, a bit of volatility is probably what the Chinese central bank is after. The internationalisation of the yuan is underway where the Chinese currency is now traded in offshore hubs such as London.
According to the global transaction services organisation, SWIFT, the yuan is already the seventh most-traded currency in the world, after the highly liquid top six currencies, rising quickly in just a couple of years. And this is without it being tradable or convertible.