Tuesday, June 17, 2014

Chinese Yuan drop maybe a dangerous sign

Chinese leaders have an easier time controlling their currency than their corruption. The government has alternated between pegging the yuan to the dollar and allowing it to move up or down in tightly controlled bands. Some say the huge devaluation of January 1994, in which the yuan moved from 5.8 to the dollar to 8.7, laid the groundwork for the collapse of other Asian currencies five years later.

The yuan was repegged in May 1995 at 8.32 to the dollar. But under immense pressure from Washington, which claimed China was purposely undervaluing its currency to increase exports, the yuan was allowed to reach 6.83 to the dollar in July 2008. The recession brought another peg that lasted until June 2010. From that time until early this year, the yuan has appreciated an average of 2.5 percent annually, with low volatility.

That, of course, has attracted a huge number of speculators who see the yuan's appreciation as a safe, one-way bet to leverage to the hilt. Such strong demand has kept the yuan trading close to the 1 percent limit above the rate that the central bank sets daily.

The profit opportunity has even encouraged speculators to smuggle money into China. Some Chinese exporters, for example, inflate their invoices. That allows more dollars to be remitted to China than the goods are worth. Similarly, some Chinese companies borrow yuan to finance exports. Then they send the exported goods back to China, where the imports are paid for in dollars. They repeat the process to generate even more dollars.

Moving goods in and out of the Shenzhen special trade zone also provides a means to ship dollars into China to speculate on anticipated yuan appreciation. Investment products sold to Chinese exporters to hedge against the dollar are also used for yuan speculation.

Chinese foreign currency reserves leaped $510 billion last year to $3.8 trillion, suggesting money came in through illegitimate channels. About $150 billion of $244 billion in capital inflows was hot money. In January, $73 billion flooded in -- the biggest monthly inflow in a year.

Chinese leaders are clearly unhappy with the one-way bet they are providing to speculators as they also seek to curtail excess liquidity. So in late February, the People’s Bank of China, the nonindependent central bank, engineered an unexpected drop in the yuan by buying dollars and selling yuan. Sure, this fits in with China’s long-run plans to free the yuan and make it an international currency. And China did increase the trading band from 0.5 percent to 1 percent. A weaker yuan, furthermore, helps Chinese exports. But the timing implies this policy reversal was a blatant attempt to punish speculators.

The effects were swift and significant. Global trading in the yuan dropped 8.5 percent in February from January, pushing it from the seventh to the eighth most-used currency.

The Chinese government, which doesn’t want to push the currency into free-fall, is playing a dangerous game. A weaker yuan revives criticism from the U.S. and others that China is a currency manipulator. And further weakness could cause foreign capital to flee China in anticipation of even more declines. Besides, dollar-buying only adds to China's embarrassing horde of foreign currency.

Nevertheless, as we know from repeated historical examples, runs on currencies are difficult to stop. Chinese leaders, in their zeal to punish speculators and assert control, may have erred.