[Christopher Balding] China is fighting in the wrong fight for the yuan

[Christopher Balding]  China is fighting in the wrong fight for the yuan

With the US dollar reaching record highs this year, the People's Bank of China appears determined to keep the yuan at 7 to 1 or more. This barrier is of little technical importance, but its psychological value and the central bank's interest in holding the line are enormous.

While it is difficult to confirm, there is strong evidence that PBOC is controlling prices in the foreign exchange market. Renminbi forward rates are essentially unchanged from spot rates, which can last up to three months. Astonishingly, implied forward rates of three months to almost two years point to a strengthening of the yuan. As the Chinese currency has weakened steadily in recent months, the futures markets are announcing that the bottom has been reached and that strength will follow.

This futures pricing would not be plausible over a normal currency market due to the narrow spread over time. As we are less sure about the future, time is the big risk of derivatives. Therefore, prices tend to expand further. A longer-term US dollar against the euro and the pound indicates changes in time of up to 10 percent. By contrast, the yuan futures market is flat and spans three years, suggesting that the currency has found a perfect balance.

When traders push the renminbi down, they encountered strong resistance from the PBOC. Since July 1, the market has been steadily weakening against the central bank's fix by nearly 0.01 yuan a day. By contrast, in the first six months of the year, the average difference between daily market movements and official fixing rates – even as the currency fluctuated – was about one tenth of the gap. This means that the central bank fix was much more in line with market expectations.

What makes the psychological confrontation with the demons of the PBOC is the close correlation of the currency with the basket, which determines its value. While the central bank says that the market is pricing in the yuan, it's really other currencies that come through the basket. As the dollar gains in value, we should expect downward pressure on the renminbi, and that's what we see.

However, the psychological effect is different from the technical reality: Seven is considered a key to trust in China. While the currency reached similar levels in December 2016, the last 7 yuan weakening was close to 2008's global financial crisis.

An appreciation of the currency is seen in Beijing less as the price of an asset, but rather as a barometer of the rise of the nation on the world stage. An emerging China should not suffer currency weakness, though this weakness is due to the official design of the basket to which it is linked.

In fact, there is little cause for concern. China's external debt has risen slightly faster in recent years, but remains both absolute and relatively low. The yuan has weakened against the dollar relative to many other currencies, particularly the emerging markets. The PBOC is fighting this tide for a futile struggle as the Federal Reserve raises liquidity and raises interest rates.

The central bank's efforts to shift prices are having a poor record everywhere. If China wants to increase market influence, this should signal a willingness to let the yuan keep track of the basket of currencies, even if it weakens on the strength of the dollar.

Instead of keeping the currency above 7, the central bank should signal that market mechanics should work.

Christopher Balding
Christopher Balding is a former associate professor of economics and business at HSBC Business School in Shenzhen and author of "Sovereign Wealth Funds: The New Crossroads of Money and Power." – Ed.

(Bloomberg)

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