(Revised) China widen yuan’s trading band: a signal for economic overhaul

Finally Chinese central bankers are making really beneficial policy. It was a very clever move for People’s Bank of China (PBOC) to widen trading band of Yuan to 2% from 1%, a move that help China shake out hot money from its financial system, improving effectiveness of monetary policy. What do I mean by this?

For many who may not know about exchange rate regime in China, here is some background information. China is one of the very few peculiar countries using “managed floating exchange rate regime”. The key word here is “managed”, which means PBOC set daily peg for trading of the Yuan against the U.S. dollar (a.k.a. the parity rate, albeit the fact that this rate is not market determined). Trading price for a day cannot exceed 1% above or below the parity rate. If the price ever exceeded this band, the PBOC would step in to intervene the market. This is very much like OMO intervene in the federal funds market to make sure effective fed fund rate move around the target rate.

Early in March, PBOC announced it would widen trading band to 2%. This might not sound like much, but as little as 1% has significant impact on the Forex market. You could see one of the reactions 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 magnify gains when Yuan appreciate but would also cause more losses if the Yuan fall below a certain level.

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

Since 2005, Yuan has been appreciating steadily, with volatility as narrow as 1%. What other investment could yield better than betting on appreciating Yuan? While QE causing investments in U.S unpalatable, and debt crisis steering money away from EU, international capital seeks a new place to rest. China, with double benefits of high interest rate and appreciating Yuan, becomes the best option.

While international investors are happy about their new discovery, Chinese people are paying the bill. 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.

What should China and Chinese government do about this? There was no sign of change for years until just now.

Riding on the tide of economic and financial overhauls initiated by Chinese top officials earlier this year, PBOC finally move to depreciate Yuan and widen trading band.

Many people misinterpreted this move as the central bank trying to help Chinese exporters by lowering the price for their goods internationally. However, given the context, this is very unlikely. Chinese government had stated explicitly that the economic reform would include less intervention of exchange rate and export market. Relying on the old model of propelling the economy growth is no longer an option. Therefore, fueling exports is not the motivation behind PBOC’s unexpected move.

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

But punishing speculators apparently is not the ultimate goal. Why is this beneficial in the long run to China by shaking out hot money from the system? How is this move coincides with China’s other economic reform? I will talk more about this in my next post.