China appears to have quietly adjusted its currency policy in response to the deepening euro zone debt crisis, slowing the yuan's steady appreciation while trying to nip speculation of yuan depreciation. The balancing act comes as inflationary pressures come off the boil and economic growth slows in the world's second-largest economy, giving Beijing more room to fine-tune policy.
The authorities are not expected to alter the yuan's upward ascent due to international criticism that its currency is undervalued, but it can afford to temper the yuan's gains. The euro zone crisis has triggered a run into the safe haven dollar, with the US dollar index against a basket of major currencies jumping 6 percent in September, encouraging Chinese firms to retain dollars.
That gave the People's Bank of China (PBOC) a chance to slow the pace of yuan appreciation. It did so by simultaneously dampening speculation it would tolerate a sharp weakening. Thus the PBOC fixed high mid-points, or its reference rate, from which dollar/yuan can rise or fall 0.5 percent each day, even as the yuan successively hit the bottom end of its daily trading limit.
Traders see the yuan appreciating to around 6.30 versus the dollar by the year-end, implying it is set to rise 4.6 percent in 2011. But that lags a 5 to 6 percent appreciation that dealers had expected for the most part of this year. It ended on Thursday at 6.3465, for a gain of 3.8 percent in the year to date. The bulk of the gain, 3.3 percent, was chalked up in the first eight months when China used the currency to help fight inflation.
For 2012, the currency is still expected to appreciate 3 to 4 percent, although that will be less than about 5 percent expected by dealers trading on the onshore market, China Foreign Exchange Trade System (CFETS). "The yuan is expected to continue to appreciate in the foreseeable future, but the potential may be more limited," said a senior trader at a Chinese commercial bank in Shenzhen.
"Stability is now the catchword because of the euro crisis-driven global economic and market uncertainties." China typically tends to keep the yuan's exchange rate stable in times of global financial turmoil. For instance, the government pegged the yuan to the dollar for two years until June 2010 during the 2008 financial crisis.
PBOC TACTICS Spot yuan traded at Shanghai-based CFETS was quoted around 6.3470 to the dollar on Friday. Steady yuan gains pushed Chinese firms to sell most of the dollars they earned until the worsening of the euro debt crisis sparked a global dollar rally in September.
Offshore, the dollar rally also sparked a wave of short-covering in the US currency, helping to create a negative spread between spot yuan in Shanghai and Hong Kong, pushing Chinese companies who need dollars to buy more at home. The negative spread hit a record high of 1,311 pips on September 23, a level wide enough for corporations to also conduct some arbitrage trading. It fell back to 220 pips on Friday.
Dollar demand onshore overwhelmed supply from time to time, creating the impression the yuan had begun to depreciate. Some offshore investors also shorted the yuan recently amid signs China's economic growth was slowing under the weight of a global slowdown and a series of tightening measures put in place since October last year to help manage inflation.
To counter speculation that policy has been reversed, the PBOC kept the mid-point relatively strong. A high mid-point coupled with dollar demand caused the yuan to hit a slew of limit downs in the past two months onshore. The PBOC fixed the mid-point so high on some days that even at limit down, the yuan closed firmer than previously. The yuan's trading limits are set against the PBOC's mid-point.
On the surface, the market seemed at odds with the central bank over the value of the yuan but traders say the government is in full control. There is no real shortage of dollars, not in a country with $3.5 trillion in foreign exchange reserves.
The PBOC holds the bulk of these reserves on behalf of the government as it has bought most dollars flowing into China to maintain a tight grip on the yuan's exchange rate for more than a decade. The central bank can easily inject dollar liquidity into the mainland market to offset any sort of dollar shortfall. "If this market is short of dollars, it is the government's intention to let it be so, and the purpose is to keep the yuan's value under control," said a European bank dealer in Shanghai. "The government's new policy appears to be one of keeping the yuan stable, not to let the currency appreciate significantly nor let it depreciate in the medium term."