The People’s Bank of China (PBoC) took some confusing measures with regards to the China yuan, also known as the renminbi.
Investors saw the yuan fall sharply as China narrowed the currency’s daily fixing rate the most since July 2012. The yuan previously traded in a band plus or minus 1% of a rate which is set each morning. This percentage doubled to 2% percent.
Economists expected this move for some time. Sacha Tihanyi, a Forex Specialist at Scotia Bank, was harsher than most. “It is obvious that Chinese financial reform is being pushed ahead at a decidedly brisk pace,” said Tihanyi.
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 reduced liquidity, but only under the assumption that dollars are exchanged back into yuan.
In January of 2014, banks loaned US$218 billion to consumers: the largest amount ever and an action which substantially raised liquidity.
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.
Beijing had to force growth to prevent social unrest and unemployment. Therefore, a huge stimulus package worth US$600 billion was introduced in 2008. Money went toward infrastructure projects such as roads, airports, and trains. This created jobs… at least for a while.
The plan worked as low unemployment and high GDP growth continued throughout the following years. But the issue is that China invested in developing fixed assets which produce no cash flow and are unsustainable.
Once 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 suddenly pop because the resulting unrest would cause the same problem Beijing wants to avoid. They also realize the current path of infrastructure-led growth cannot last forever.
As a result, China decided to focus on what worked well to begin with: global trade. The renminbi must fall against the dollar because of this.
However, there’s another problem. Land prices and wages in China have both risen to record levels because of the U.S. Federal Reserve’s quantitative easing program.
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 yuan into dollars. But assets must be sold and converted into dollars to prevent inflation.
The delicate balancing act that investors are noticing implies an uncertainty in whether the renminbi will rise or fall. Forex traders should be cautious.