Why China is warning of yuan speculation when the currency looks so stable

The yuan-dollar rate is stable but the official yuan index has surged against a basket of currencies. There are legitimate reasons for this, such as strong exports
But the concern is of the systemic risk of proprietary carry trades and the massive leveraging at banks and financial firms looking to profit from higher yuan returns

Hao Zhou

Published: 10:00pm, 1 Dec 2021

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In a meeting hosted by the People’s Bank of China, Chinese financial regulators’ warning against so-called speculation in the foreign exchange market has attracted much attention. Yet the Chinese currency has been quite steady this year, with the US dollar-to-yuan exchange rate mainly keeping within a narrow range of 6.3-6.4.

Compared to many other emerging market currencies, such as the Turkish lira that recently hit record lows, the Chinese currency looks much more resilient. So why, despite a stable currency, do the authorities see a risk of speculation?

Although the Chinese authorities constantly stress the importance of stability, it is hard to define. In the world of foreign exchange, there are a few dimensions of “stability”, and sometimes these dimensions are contradictory.

For instance, while the dollar-yuan exchange rate remains stable, the official yuan index, which measures its performance against a basket of currencies, has been surging over the past few quarters.

So far this year, the official China Foreign Exchange Trade System (CFETS) index has climbed by about 7 per cent. If this momentum is sustained, the yuan index is likely to generate its best annual performance since 2015 when it was introduced.

Let’s dial back the clock to a few years ago. One important reason behind the introduction of the official yuan index was to gauge the performance of the Chinese currency, to manage market expectations amid massive depreciation pressure.

The Chinese currency experienced a wild depreciation against the US dollar following the so-called one-off devaluation in August 2015. To stabilise the currency, the Chinese authorities used many instruments, which included the official yuan index. By regularly releasing data on this index, the PBOC provides its official gauge of the currency’s performance.

Technically speaking, as the index is calculated based on a basket of currencies with the US dollar taking less than 30 per cent of the weight, it can dilute the dollar’s impact on the yuan. The introduction of the yuan index has therefore given the PBOC more leeway to manage its currency, particularly when the dollar is rising strongly.

For instance, if the yuan depreciates against the dollar, but the official yuan index is stable, the PBOC normally states that the Chinese currency is trading within a reasonable range. In this way, the PBOC signals that the market should not panic about the yuan weakening, as many other currencies are also doing the same.

The market has accepted this sort of policy communication and sees that it is more important to look at the yuan index, rather than dollar-yuan exchange rate alone. The government work report delivered during the National People’s Congress made clear that the aim of China’s foreign exchange policy is to keep the yuan exchange rate basically stable, at an appropriate and balanced level.

Since 2017, the average annual return of the yuan index has been 0.11 per cent, which reinforces the idea that a stable yuan index is a major foreign exchange policy target for the PBOC.

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But given that the yuan index has surged strongly this year, the market has good reason to ask if the PBOC has changed its policy target. There is no clear answer for now, but recent meetings by PBOC seem to suggest that the central bank might be also concerned that the currency is becoming too strong.

Certainly, there are many factors attributing to yuan strength over the past few quarters. In particular, the current account surplus this year is likely to hit a multiple-year high, thanks to strong export performance.

Meantime, overseas spending, particularly on education and tourism, has been shrinking massively due to virus fears and restrictions.

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Also likely to have added impetus on the Chinese currency is the positive carry trade in long yuan positions, which allows investors to pocket the difference between the much higher yield on the yuan compared to most of the currencies in its basket. This carry trade, if it prevails, would result in a stronger yuan index.

But in proprietary trading, when banks and financial companies invest their own money rather than their clients’, this kind of carry trade normally involves massive leveraging. From the perspective of China’s financial regulators, this is a very risky activity, particularly when disorderly unwinding happens.

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This explains why the Chinese regulators warned against currency speculation in the recent meeting and asked the banks to take a prudent approach to proprietary trading.

However, the PBOC also needs to avoid sending signals that are too strong to the market, in case the foreign exchange market changes expectations overnight and enters crisis mode, like what happened after the 2015 one-off devaluation.

All told, the yuan exchange rate is at a tipping point. From the perspective of economic fundamentals, the strong Chinese yuan is clearly inconsistent with the gloomy growth picture.

From a policy perspective, an over-strong currency would not only reduce export competitiveness, but also dilute the policy target of maintaining a stable yuan vs a basket of currencies. In China’s foreign exchange market, the dominant carry trade has to contend with the risk of an expected rate lift-off in the United States and other major economies.

Hao Zhou is senior emerging markets economist at Commerzbank