A sharp and sudden slide in China’s yuan is forcing investors to rethink one of the most reliable trades in financial markets over the past four years: betting on gains in the Chinese currency.
Over the past 8 years, yuan has strengthened by about 33%, making investing in yuan related derivatives an almost free money to invest in for both institutional and individual investors. Chinese exporters have been big buyers of derivatives because they allowed them to hedge against the rising yuan. In many cases, the businesses are losing money in their operations but make profits because of the hedges, which generate a monthly income.
However, last week, guiding by the PBOC, renminbi dropped to its weakest level in seven months.The easy money gets tougher.
The earliest reaction was this recent decline in the yuan reflects economic fundamentals, based on the fact that GDP slowed to 7.7% in the fourth quarter from 7.8% in the third quarter.But the fact that the exchange rate in China is not determined by the market rules out this possibility. For people who may not know about China’s foreign exchange regime: the exchange rate was determines by China’s central bank based on a basket of currency (including USD). Specifically , a reference point for the yuan is set daily and then lets it trade 1% higher or lower. So the change in yuan is basically still driven by policy makers rather than market forces, although few people willing to admit that.
From my point of view, there is at least tow reason why PBOC alter the trend of RMB movement.
The first being to shake out speculators as China prepares to allow a wider trading range for yuan, an essential step toward Chinese foreign exchange reform.Recent years, there has been a huge inflow of speculative money (or hot money ) to take advantage of both rising Yuan and higher interest rates. This could be problematic for China, whose central bank takes control over the exchange rates. To stabilize the exchange rate, PBOC and its state-owned affiliates has to absorb dollars, making China’s foreign reserve explode over the past few years. Meanwhile, inflation arise as banks exchange dollar into RMB and dumped them into the market. This has caused huge inflation and asset price bubbles in China.To curb the inflation and implement the long overdue exchange rate marketization, China is now trying to depreciate yuan and shake off speculative money from the system to improve financial stability. China would need a more stable environment to unfold the exchange rate reform.
The second reason being to prepare for a foreseeable economy downturn brewing so long in China. It is known that China’s shadow-banking imposed a huge threat on the financial system of China. As QE retreating, hot money used to boost the irrational exuberance in asset market will retreat as well. The burst of bubble would obviously result in a huge economy downturn in China. Therefore, the only quick solution to prevent economy from recession would be to increase export.