The People’s Bank of China (PBoC) has taken some confusing measures with regards to the China yuan, also known as the renminbi. Analysts and currency traders are taking note.

Investors saw the yuan fall sharply as China narrowed the currency’s daily fixing rate the most since July 2012. It was previously allowed to trade in a band plus or minus 1% against a rate which is set each morning. This percentage has now doubled to 2% percent.

This move has been expected for some time. But Sacha Tihanyi, a Forex Specialist at Scotia Bank, was harsher than analysts anticipated.

“It is obvious that Chinese financial reform is being pushed ahead at a decidedly brisk pace,” said  Tihanyi. “It looks like higher two-way volatility in the renminbi is now officially confirmed with this step.”

However, the shocking part is when you consider these rate changes in the context of the PBoC’s other recent moves. In December of 2013, the country sold US$48 billion worth of United States treasuries. The move would reduce liquidity, but only under the assumption that dollars were exchanged back into yuan.

In January of 2014, banks loaned US$218 billion to consumers: the largest amount ever and an action that would increase liquidity.

 

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Is China attempting to increase or decrease the value of their currency? They may not even know the answer.

The Future of China’s Yuan? Uncertain

These bizarre actions have alarmed forex traders and investors because they highlight a weakness in the Chinese economic system.

Since the beginning of the country’s growth story, the yuan has been rising against the U.S. Dollar as more money flowed into China. This was fine until the economic crisis of 2007/8. At this point, the western world stopped buying Chinese manufactured products.

Because the government must prevent social unrest and unemployment, they had to force growth in somehow. So, a huge stimulus worth US$600 billion was introduced in 2008. This money was mostly used for infrastructure projects such as the building and improvement of roads, airports, and trains which helped to create jobs.

The plan worked as low unemployment and high GDP growth continued throughout the following years. But the issue is that since China invested in the development of fixed assets that produce no cash flow, it is unsustainable. As projects were completed, the country had the same problem as it did at the beginning of the financial crisis.

 

China’s Unpoppable Bubble

This leaves Chinese authorities in an awkward position. The bubble cannot be suddenly popped, as the unrest would cause the same problem Beijing wants to avoid. They also realize that the current path of infrastructure-led growth cannot last forever.

Therefore, China decided to focus on what worked well to begin with: global trade. As such, the renminbi’s foreign exchange rate against the dollar must be lowered.

This has created another problem. Because of the U.S. Federal Reserve’s quantitative easing program, land prices and wages in China have both risen to record levels. Further inflation would not only multiply this issue, but make manufacturing in China even less competitive compared to countries such as Vietnam and Mexico than it is already. It defeats the purpose of solving their problems though an increase in trade,

All of this explains the odd moves which seem like an attempt to achieve two different goals at one time. To cheapen their currency, China must exchange it into dollars. But to prevent inflation, yuan assets must be sold and converted into dollars.

The delicate balancing act that investors are noticing implies an uncertainty in whether the renminbi will rise or fall. Forex traders should be cautious.

About Liana Lie

Liana Lie has been an equity analyst in the greater China area for over 20 years. She is also a specialist in retail, office and residential, real estate in Hong Kong and Shanghai.

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