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Calming the yuan

Time for Beijing to give up targeting exchange rate levels

  © AP

In ancient China, time was marked in the cyclical rise and fall of dynasties. A linear movement of growth and change wasn't considered.

Whether or not time is still cyclical for China, it certainly seems to be for the yuan. The first week of 2017 looked very much like that of 2016. Both years began with worries about the strength of the currency and the level of Chinese foreign reserves.

This year started with the currency just a touch under the psychologically important but economically insignificant level of 7 to the U.S. dollar. The psychological importance of this level was plainly illustrated when the People's Bank of China, the central bank went so far as to issue a statement in the middle of the night to deny an internet report that the currency had traded over the threshold.

This was then followed, as happened last year, by a PBOC-led short squeeze of offshore yuan traded in Hong Kong. As per last year, overnight borrowing rates for the offshore yuan shot up over 60% and it rallied from just under 7 to 6.82 to the dollar although it is now slowly trending back down again.

In the onshore market, the yuan has remained relatively stable. The daily fixing around which the currency trades has been pushed up and down by the PBOC, not moving in with the official basket of foreign currencies designated by the central bank, but rather in a clear sign of intent to short-sellers who would dare challenge the authorities.

All the talk in the currency markets is around Chinese capital controls and what Beijing will do to stop the yuan from falling further. For many years, Chinese citizens have been limited to buying only $50,000 of foreign currency a year, a quota refreshed each Jan. 1, but this year has seen intensive checks and requirements for greater disclosure to discourage conversions.

An early Lunar New Year, falling this year on Jan. 28, is partly blamed for stresses within China's currency and money markets as there is an annual squeeze on liquidity at this time. This was coupled with stress in the bond market which saw some erratic moves in long-dated but illiquid issues on the Shanghai Stock Exchange which led to a temporary trading suspension and a dramatic fall in bond futures.

None of this really amounted to a crisis and was more like a storm in a teacup. It is the Chinese themselves who have allowed such minor currency moves to take on outsized significance.

Since removing the yuan's hard peg to the U.S. dollar in 2005, the PBOC has set a daily midpoint rate and a range within which the currency can trade. The original range was 0.5% up or down but it has been widened to 2%. The midnight notice about the currency not trading below 7 was completely unnecessary. At the time, the midpoint was 6.95 which by the PBOC's own rules would allow trading to touch 7.09.

Own worst enemy

The problem is that the trading range has hardly ever been used in any meaningful way and almost all violent moves of the currency are due to heavy-handed and manipulative efforts by the PBOC. The trading band pays lip service to liberalization but the reality is that the government has never really given up control of the yuan's movements. In fact, its interference has only increased in recent years.

For some other emerging market or an economy in crisis, such interference perhaps could be forgiven but China promised much better behavior. How can an economy growing at more than 6% be in crisis? How can an international reserve currency require overnight interest rates of 60%?

These contradictions illustrate how China has failed to embrace its own plans for reform and how the international community has been too complacent in accepting Chinese promises at face value. Of course, the International Monetary Fund is not going to make a change again to their special drawing rights basket after adding the yuan last October. They will not throw it out but surely level-headed and honest IMF officials must feel betrayed by China's actions.

As for the immediate concerns of the PBOC and the currency, the short squeeze is mainly over. The next few months will likely see a somewhat stronger currency as the leadership strong-arms state-owned enterprises and tycoons to repatriate funds to strengthen the yuan.

But the trend is clear: the currency will continue to weaken. Some bold forecasters are predicting levels of 8.40 to the dollar in coming years and outspoken ex-central banker Yu Yongding has been quoted as saying that China shouldn't let the currency weaken more than 25% this year. This is an incredible statement as a fall of that magnitude would take the yuan down to 9.2, truly a historically low level. Surely things aren't that bad?

Will anything be learned from the events of the new year or is Chinese financial time truly cyclical? The PBOC needs to convince political leaders that the current strategy of targeting arbitrary exchange rate levels is unproductive.

China can't simultaneously look to fix the currency level to the dollar, track a basket of currencies and maintain reserves of $3 trillion. Slowly the leadership is moving away, albeit at a snail's pace, from the fixing of economic growth targets. More importantly, however, it should not make the same mistakes in the currency market.

China will muddle through this mini-crisis. Capital controls, strong-arming of markets and restricted activity will win out in the short term but the longer term costs grow by the day. China has shown an incredible ability not to solve problems but to avoid the consequences of them at ever greater indirect and long-term costs. It's about time Beijing effected solutions, not avoidance.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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