Cooling down hot money: China widen Yuan trading band.

Finally Chinese Central banker are making some real beneficial policy. I think it is a very clever move for PBOC to widen its trading band of Yuan to 2% from 1%, as this really help Chinese economy shake out hot money from the financial system, thereby improving effectiveness of monetary policy. What do I mean by this?

For many who may not know about Chinese exchange rate regime: China is one of the very few peculiar country using “managed floating exchange rate”. The key word here is “managed”, which means People’s Bank of China set daily peg for trading of the yuan against the U.S. dollar (a.k.a. the parity rate, albeit the fact that this is not market determined). Then the trading would start for the day where price cannot exceed 1% above or below the parity rate. If the price ever exceed this band, then the PBOC would step in and intervene the market.

Last Saturday, PBOC announced it would let the trading range widen to 2%. This might not sound like much, but as little as 1% has significant influence in the forex market. You could see a reaction to this is that the yuan fell to its lowest level in 10 months, sparking paper losses estimated in the billions of dollars on leveraged bets that the currency would keep appreciating. Individual and institutional investors have been piling up options that would magnified gains when yuan was appreciating but also causing more losses if the yuan falls below a certain level.

Why is PBOC doing this to the poor investors? Well, as the saying goes, there is no free lunch.

Since 2005, the Yuan is appreciating steadily and the trading band is as narrow as 1%, this allows a greater chance of winning if investor bet on appreciating yuan. As major financial market like U.S yielding low interest rate during QE and EU undergone debt crisis, investor seek alternative places to invest there money in. And China become one of the best options , because it not only offer high interest rate, but on top of that a double benefit of appreciating yuan. Many people concern that the central bank engineered a decline in the yuan’s value in order to help Chinese exporters by lowering the price for their goods internationally.  As I see it, this is very unlikely, since this would mean that the Chinese government is still relying on the old model of propelling the economy growth. Beijing had announced that it would implement economic and financial overhauls this year, including less intervention of exchange rate and export market. Therefore, fueling exports is not the motivation behind PBOC’s move of depreciating yuan and widen trading band.
According to central bank officials, the PBOC’s attempts were aimed at thwarting short-term speculators betting on the yuan’s continued rise and introducing greater two-way volatility into its trading, as the bank was preparing for expanding the trading band. The influx of speculative capital has complicated China’s efforts to manage the economy, contributing to property bubbles and injecting excess cash into the financial system.

Widening the band now shows that “the central bank is pretty satisfied with the effort to punish speculators,” a PBOC official said.

But I guess the bigger goal is more then to punish speculators. I will talk more about the benefit to China of increasing uncertainty of Yuan’s value and how it coincide with China’s other economic and financial reform.