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George Magnus: Behind the mystery of the falling yuan

In the last several days, while the world’s attention was focused on headlines coming out of the Ukraine, financial markets were taken aback by the abrupt weakening of the Chinese yuan against the U.S. dollar.

     The fall was not large, but broke a long-term trend of managed appreciation in which the yuan had been hugging the top end of a narrow, plus-or-minus 1% fluctuation band. Although the operations of the People’s Bank of China, the country's central bank, are not transparent, markets have been accustomed to its close and consistent management of the exchange rate. Why, then, did the PBC cause the yuan to change direction suddenly?

     Like so many things involving China, views tend to be binary: Either the PBC’s actions were totally benign and merit little further comment, or there has been a major change in exchange rate policy toward using depreciation as a tool to boost exports and stimulate growth. Unsurprisingly, actual situation is more ambiguous.

Likely stories

There are two main plausible explanations for recent developments. First, China’s leaders have promised to allow markets to do more to determine prices, including expanding the role of foreign currencies. A widening of the trading band to plus or minus 2% had already been planned, although without a specific time frame. With the National People’s Congress, China's parliament, due to meet on March 5, it is conceivable the PBC was simply preparing the ground for an announcement and trying to move the yuan a little lower, after which it could appreciate again in due course.

     Second, the PBC may also have wanted to halt the “carry trade,” which is just another name for currency speculation. This is a practice in which state-owned enterprises and other local entities have been especially active, rather than hedge funds or professional speculators. It involves borrowing dollars from banks, mostly in Hong Kong, but also in Singapore and elsewhere, and bringing them to China to lend at significantly higher interest rates locally, while taking advantage of a rising yuan in the interim to lower repayment costs when the loans mature.

     These “hot money” flows amounted to more than $150 billion in 2013, compared with a total rise in currency reserves of $433 billion. Some of the increase came from the over-invoicing of exports, which the authorities have since clamped down on, but much was probably due to foreign borrowing by state-owned enterprises, corporations and banks. These flows have complicated the PBC’s task of managing liquidity in the Chinese economy, and have fueled credit creation, which the monetary authorities are keen to control -- so far with little success.

     China’s broadest published credit aggregate, called “total social financing,” has been rising rapidly for a long time. Although overall growth slowed in January to 17.5%, compared with over 19% in the second half of 2013, it is still expanding twice as fast as nominal gross domestic product, which means China’s ratio of nonfinancial debt to GDP of 230% is continuing to increase at an alarming rate. Published data, moreover, do not capture all credit flows from asset-management companies and securities firms, or all foreign exchange-related inflows. It would not be surprising, therefore, to discover the PBC was trying to discourage expectations of a one-way street for the yuan, in order to take a bit of the sting out of foreign exchange-related financial capital inflows.

      There is a third and more extreme explanation. The now-familiar pattern of slowing economic growth at the start of the year has returned, and is visible in the relative weakness in the country’s January purchasing managers index and other industrial indicators, and the lackluster performance of exports. The weaker Japanese yen, moreover, has reduced China’s competitiveness in certain products. Further, stresses in the financial system, including default risks, have been rising.

Less than meets the eye

Since the option of stimulating infrastructure and credit demand is now much more difficult than it was in 2012 and 2013, a depreciation of the yuan would give exports and GDP growth a boost and compensate for a future weakening of investment growth and rising debt-service problems. However, such a move does not seem plausible so soon before the congress convenes. In any event, China’s leaders are well aware of the risks that such a policy would run. It would seriously strain Sino-U.S. relations, and put China at the center of currency and deflation wars globally. It would also raise the specter of a trade war in Asia, one that could also involve Japan.

     For the moment, then, it seems the weakening of the yuan was engineered for quite specific purposes and does not represent a major policy shift. Nevertheless, we should remain alert. The root of most of China’s current economic problems is the failure, so far, to control credit creation and the expansion of the shadow banking system. The country is in the throes of a huge structural and policy transition, and it wouldn’t take much for the authorities to mistime important sequencing issues in credit control, financial innovation, capital account liberalization and economic reform. The long-term direction of the yuan is not yet assured.

George Magnus is a senior independent economic adviser at UBS and author of "Uprising: will emerging markets shape or shake the world economy?"

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