The devaluation of the yuan
The battle of midpoint
China initiates market reforms of its currency, then backtracks
Aug 15th 2015
TRICK question: did China’s central bank intervene over the past week to weaken the yuan or to strengthen it? Given all the headlines about devaluation, weakening would seem the obvious answer. In fact, the opposite is true: it first tried to stand aside, giving the market more say in the yuan’s value, and then backtracked, intervening to stem the ensuing decline. The volte-face reveals much about both the oddities of China’s economy and the difficulty of reforming it.
Every morning, marketmakers such as the big state-owned banks submit yuan-dollar prices to the People’s Bank of China (the central bank). It then averages these to calculate a “central parity” rate, or midpoint. Over the course of the day, the PBOC intervenes to keep the exchange rate from straying more than 2% above or below the midpoint.
In theory, it is the marketmakers, not the central bank, that set the midpoint and thus the trading band. In practice, the PBOC gets marketmakers to submit rates that will yield its preferred midpoint, irrespective of market sentiment (state-owned banks are pliant, after all).
Critics in America and elsewhere have long alleged that China has manipulated the market in this way to keep its exchange rate cheap. They had a point up until 2012 or so.
For much of the past year, however, the central bank has in fact tipped the scales in the opposite direction, preventing a depreciation even as the Chinese economy weakened and the dollar surged. In recent months especially, trading of the yuan has regularly swung towards the weak end of the 2% band, but the central bank has nudged it back up by orchestrating stronger midpoints.
The reform the PBOC announced on August 11th sought to change this. From now on, the central bank declared, the midpoint would simply be the previous day’s closing value. Given that traders had been selling and buying yuan at a big discount to the manipulated midpoint, the new market-determined midpoint immediately fell by 1.9%, the biggest single-day drop in the yuan’s modern history.
That led to an even weaker market-determined midpoint on August 12th, whereupon the yuan fell yet again, sparking fears that the currency might be on the brink of a rout. It was at this point that the central bank intervened. It ordered state-owned banks to sell dollars and buy yuan, propping up the exchange rate at the very time that it was being accused of devaluing it.
This tug-of-war could play out for weeks, with traders repeatedly testing the limits of the PBOC’s tolerance for depreciation.
This raises the question of what the central bank is hoping to achieve. The most popular explanation is that it wants to stimulate its sluggish economy by cheapening its currency. The depreciation, after all, came just a couple of days after a surprisingly big drop in exports. However, the scale of the yuan’s weakening belies such a motive (see chart). The initial 2% devaluation only undid the previous ten days’ worth of appreciation in trade-weighted terms.
The yuan remains more than 10% stronger against the currencies of China’s trading partners than it was a year ago. Much bigger falls would be needed to make a difference. But Chinese officials have forsworn a large one-off devaluation, believing it would undermine faith in the yuan and would do little to help the economy, since it would just persuade others to let their currencies weaken too.
Instead, another event seems the main trigger for the central bank’s actions. Later this year the IMF will decide whether to include the yuan in the select group of currencies it uses to calculate the SDR, its unit of account. Inclusion would amount to declaring the yuan a global reserve currency. Just last week the fund hinted that the yuan is still too heavily controlled.
For the PBOC, getting into the SDR has never been just about prestige. Rather, it has been using this objective as a means to push for reforms that remove some of the policy distortions still hobbling the economy. Introducing a truly floating exchange rate is an essential part of its programme.
Yet there is another complication. Some $250 billion of “hot money”, equivalent to roughly 2.5% of GDP—an unprecedented amount—has left China over the past year as the economy has slowed. Strong inflows via the trade surplus have allowed the PBOC to absorb these losses so far, but it is wary of doing anything that might accelerate capital flight. A sustained devaluation would do just that, inviting speculators to short the yuan. Hence the central bank’s apparently contradictory actions, in letting the yuan fall and then trying to make it stop. As ever, China’s willingness to trust market forces extends only so far.
Every morning, marketmakers such as the big state-owned banks submit yuan-dollar prices to the People’s Bank of China (the central bank). It then averages these to calculate a “central parity” rate, or midpoint. Over the course of the day, the PBOC intervenes to keep the exchange rate from straying more than 2% above or below the midpoint.
In theory, it is the marketmakers, not the central bank, that set the midpoint and thus the trading band. In practice, the PBOC gets marketmakers to submit rates that will yield its preferred midpoint, irrespective of market sentiment (state-owned banks are pliant, after all).
Critics in America and elsewhere have long alleged that China has manipulated the market in this way to keep its exchange rate cheap. They had a point up until 2012 or so.
For much of the past year, however, the central bank has in fact tipped the scales in the opposite direction, preventing a depreciation even as the Chinese economy weakened and the dollar surged. In recent months especially, trading of the yuan has regularly swung towards the weak end of the 2% band, but the central bank has nudged it back up by orchestrating stronger midpoints.
The reform the PBOC announced on August 11th sought to change this. From now on, the central bank declared, the midpoint would simply be the previous day’s closing value. Given that traders had been selling and buying yuan at a big discount to the manipulated midpoint, the new market-determined midpoint immediately fell by 1.9%, the biggest single-day drop in the yuan’s modern history.
That led to an even weaker market-determined midpoint on August 12th, whereupon the yuan fell yet again, sparking fears that the currency might be on the brink of a rout. It was at this point that the central bank intervened. It ordered state-owned banks to sell dollars and buy yuan, propping up the exchange rate at the very time that it was being accused of devaluing it.
This tug-of-war could play out for weeks, with traders repeatedly testing the limits of the PBOC’s tolerance for depreciation.
This raises the question of what the central bank is hoping to achieve. The most popular explanation is that it wants to stimulate its sluggish economy by cheapening its currency. The depreciation, after all, came just a couple of days after a surprisingly big drop in exports. However, the scale of the yuan’s weakening belies such a motive (see chart). The initial 2% devaluation only undid the previous ten days’ worth of appreciation in trade-weighted terms.
The yuan remains more than 10% stronger against the currencies of China’s trading partners than it was a year ago. Much bigger falls would be needed to make a difference. But Chinese officials have forsworn a large one-off devaluation, believing it would undermine faith in the yuan and would do little to help the economy, since it would just persuade others to let their currencies weaken too.
Instead, another event seems the main trigger for the central bank’s actions. Later this year the IMF will decide whether to include the yuan in the select group of currencies it uses to calculate the SDR, its unit of account. Inclusion would amount to declaring the yuan a global reserve currency. Just last week the fund hinted that the yuan is still too heavily controlled.
For the PBOC, getting into the SDR has never been just about prestige. Rather, it has been using this objective as a means to push for reforms that remove some of the policy distortions still hobbling the economy. Introducing a truly floating exchange rate is an essential part of its programme.
Yet there is another complication. Some $250 billion of “hot money”, equivalent to roughly 2.5% of GDP—an unprecedented amount—has left China over the past year as the economy has slowed. Strong inflows via the trade surplus have allowed the PBOC to absorb these losses so far, but it is wary of doing anything that might accelerate capital flight. A sustained devaluation would do just that, inviting speculators to short the yuan. Hence the central bank’s apparently contradictory actions, in letting the yuan fall and then trying to make it stop. As ever, China’s willingness to trust market forces extends only so far.
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