When the People's Bank of China (PBoC) lifted the U.S. dollar/yuan fixing rate by 1.9 percent in 2015 it stunned markets and caused widespread confusion. Economists wondered whether this was an isolated event, or if it signalled a move towards floating the yuan. Concern continues to grow today: the yuan is down 4.2 percent versus the U.S. dollar so far in 2016, and in October China’s foreign-exchange reserves fell $45.7 billion to $3.12 trillion. According to The Wall Street Journal, that decline demonstrates concern among the Chinese over preserving the value of domestic savings and assets in the face of their currency’s ongoing decline.
To understand the yuan’s most recent movements, a little background is in order. In its efforts to internationalise its currency, China split the yuan by introducing an “offshore” version (CNH), traded by the Bank of China through Hong Kong, to complement its domestic “onshore” currency (CNY). Currently, CNH exchange rates float freely against other world currencies but China's domestic CNY does not. The CNY exchange rate is pegged to a basket of international currencies U.S. dollar with a fluctuation band of plus/minus 2 percent. The centre of the band is reset by reference to the CNH market rate each day by the PBoC, which buys and sells currencies to maintain CNY exchange rates within the band. Observers can see the extent to which Chinese officials control the currency environment by following the difference between the CNY and CNH exchange rates.1
Government Controls On Exchange Rates
Many analysts believe that China maintains the CNY at too low an exchange rate to benefit Chinese exporters at the expense of exporters from other countries. But this has not always been the case: during 2014 and 2015 the CNY’s real effective exchange rate (REER) rose by 13%. During this time, the CNY was pegged to the U.S. dollar with a fluctuation band of 2% in either direction, and the midpoint of the CNY trading band was persistently above the CNH rate. In a statement at the time of the August 2015 devaluation, the PBoC explained that the central bank fixing point was nearly 2 percent above the offshore exchange rate and needed to be brought back into line.2
The PBoC said that in the future, the daily fix would take account of market currency rates. The adjustment has narrowed the gap between the CNY and the CNH, possibly making further sharp devaluations unnecessary. According to Khoon Goh, a Singapore-based strategist at ANZ Banking Group quoted in Bloomberg, "the one-off devaluation of the fix and allowing more market-based determination takes us into a new currency regime".3
As the CNY and the CNH move closer together, the need for a separate offshore currency could slowly decline. At the time the Chinese government moved to market-determined midpoint rates, it was with the hope that liberalising the CNY would enable it to be included in the International Monetary Fund’s (IMF's) SDR “basket” of currencies, and eventually become a global reserve currency. And in fact, the IMF announced just that in December 2015: the CNY joined the British pound sterling, U.S. dollar, Japanese yen and euro in the IMF’s SDR basket.4
However, many analysts believe that liberalising the CNY will mean further devaluation down the road, and that authorities could also tighten capital controls.
What Does This Means For Business?
Businesses exporting to China could see terms of trade worsen if CNY falls. Conversely, businesses importing goods and services from China may benefit from a falling CNY.
Currency fluctuations are a common risk for businesses in the import and export industry. Forward Contracts can help businesses manage their foreign exchange risk. Forward Contracts are agreements between businesses and foreign exchange providers to buy or sell foreign currency at a fixed rate of exchange on a future date. They allow businesses to lock in an exchange rate now to avoid currency fluctuations and gain flexibility when business circumstances change.
Transacting across borders presents a range of risks, not least of which is tackling the volatile world of foreign exchange rates. Read about the day the world got its first taste of FX volatility here. And watch this short video for a look at the key indicators you need to be aware of and when to watch for them: