Why Should We Care About Yuan’s Decline

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In the past week, the People’s Bank of China has been guiding the yuan lower against the dollar – by setting a weaker benchmark against which the yuan can trade. It has also intervened in the currency market by directing state-owned Chinese banks to buy dollars. According to Wall Street Journal, China’s central bank engineered the recent decline in the country’s currency to shake out speculators as it prepares to allow a wider trading range for the tightly tethered yuan.

It wasn’t market forces or traders behind the move, but that the Chinese central bank was deliberately pushing the currency lower. For a very long period of time, the yuan was long seen by investors as a currency that was only going up. Why was the Chinese central bank doing this?

Every day, the yuan trades within a tight range set by the central bank every day. However, short-term traders and increasing demand is almost constantly pushing the currency higher within that range. Therefore the central bank is trying to bluff away these traders. In this sense, fewer speculators will trade the yuan, China now hopes to have an easier path to widen the yuan’s trading range further. In the much longer term, this will make the yuan a free-floating currency that’s driven only by economic and market forces. PBOC officials have said in the past that the yuan is nearing its fair-market value, or “equilibrium level,” meaning the chances of any drastic movements in the currency are limited.

I believe that this would be a great step for China – free its currency in the long term. A freer yuan may also help China deflect foreign complaints about its currency policies. The U.S. and other advanced economies have pressed Beijing for years to relax its hold on the yuan, allowing it to rise in value and boost Chinese consumer demand. The free trade of currency will open up a wide door for the yuan to become much more prominent in trade and payments across the globe. More importantly, in my understandings, a freely convertible currency also makes the yuan a more attractive option for other central banks’ stockpiles of cash, also known as their foreign exchange reserves. The current situation is that U.S. dollar dominates the currency market as the number-one reserve currency in the world. This perfectly explained why so many central banks hold U.S. government bonds even when the U.S. economy was in recession.