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Why the Chinese yuan is weakening against the dollar

First of all, it’s not as bad as it looks. Or one should hope. China is still a closed economy. The government controls the foreign exchange rate. But one look at a USD-CNY chart and it’s obvious that the Central Bank of China is worried about something. Either a slow domestic economy, or a worsening international one. The dollar has gone straight up against the yuan since Feb. 18. The currency is now worth 6.12 to the dollar when a month ago it was around 6.04. A year ago it was 6.22, so the yuan continues to appreciate as the market expects, and as the government of China promised.

For the fifth consecutive day, the Central Bank has fixed the reference renminbi rate weaker. Over the past five trading days the CNY (onshore renminbi) has lost 0.6% against the dollar and the offshore renminbi — which tends to trade at stronger levels — has lost 1.1%.

Although the move is small relative to how most floating currencies trade, it is a significant adjustment for what is essentially still a managed currency. If the weakening persists, says Barclays Capital analysts Chris Walker and Koon Chow, it could lead to some contagion into other currencies, starting with Taiwanese Dollar and Korean Won.

Sustained yuan weakness for offshore and onshore over a few months would have even greater contagion effects.

Walker and Chow give two reasons for the Central Bank’s decision to weaken its currency.

1. The carry-trade

Speculators who are long yuan and short the dollar have added to the volatility. The market now seems to be cleaning out these short dollar positions. With risk-adjusted carry falling elsewhere, investors have also used the dollar-yuan trade to swap their currency positions for higher-yielding and longer duration onshore alternatives, mainly 10-year local government bonds yielding as much as 4.7%. This has the benefit of introducing more two-way risk in to the currency, which is prudent from a long-term financial markets reform perspective.  Moreover, it could curb the future growth of carry trade-related inflows that otherwise would complicate the Chinese authorities’ goal of deleveraging some parts of the economy.

2. New thinking at central bank

There has been a shift to a more neutral policy in a context of weakening growth momentum and looming signs of problems in the financial sector.  Let’s not forget the Industrial and Commercial Bank of China’s (ICBC) failed wealth management product China Credit Equals Gold #1.  The Central Bank has been worried about its smaller municipal lenders.  The ICBC trust fund bailout clearly raised the warning level.

If this is the main motivation behind policymakers weakening the currency, then it leaves the door open to further official dollar buying to drive depreciation if growth were to falter further, BarCap economists said on Tuesday in a research note to clients.  The last period of depreciation against the dollar since China moved away from the currency peg was between May and July 2012, when it fell around 2%.   Year-to-date, the yuan is down around 0.7% to the dollar.

Walker and Chow think the weak yuan may be temporary. But if not, it would entail greater spillover to other emerging market currencies, and potentially to developed ones like the Japanese yen.  The report did not mention which developed market currencies might be impacted, however.

Furthermore, modest depreciation and a further increase in volatility between the mainland yuan and the offshore one, aimed at stopping out carry trades, would be a short-term concern for investors.  For Barclays, the yuan will strengthen again this year, finally topping out below 6 to one for the first time.

“If we are looking at the beginning of some competitive depreciation — aimed at supporting exports and growth — the
contagion implications are greater,” the analysts wrote in a research note today.

“In such a scenario, we would expect investors to turn more defensive on regional currencies on expectations that policymakers elsewhere could adjust their currency strategy,” they said.

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