Is Chinese Centrally Planned FX Policy "Just A Silly Game"?

Submitted by Jake van der Camp via The South China Morning Post,

The mainland's foreign-exchange regulator said recent volatility in the yuan's exchange rate is normal, while playing down the possibility of large capital outflows, in a statement apparently aimed at easing market concern over a sharp currency depreciation.

South China Morning Post, February 27

Call me an artist: I always say a picture explains things best, and my chart on China's net capital flows certainly says all you need to know about why Beijing is playing silly games with the yuan again.

Let's get it straight first of all that this is indeed silly games. Until anyone in the mainland can take money freely in and out of the country, the yuan remains officially defined as funny money. There is no such thing as "normal" in the yuan exchange rate. Normal market forces do not determine it.

It is rather central government policy that is the operative factor here and, lest you think that policy results from the considered deliberations of informed experts, yuan policy over the last two years has been set by a huge crack-the-whip gyration in the balance of payments.

The chart shows you that capital inflows suddenly collapsed in 2012 and the year ended with a net outflow of almost US$100 billion.

It did not happen purely as a matter of chance. It happened because at the beginning of 2012 the authorities took the view that the yuan had strengthened enough since they had begun pushing it up two years earlier. As the second chart shows, they thus let it weaken a little against the US dollar. Almost instantly speculators decided they no longer saw a good bet in the yuan and fled. They had only come to the yuan because its steady appreciation against the US dollar had given them a currency translation profit. With that gone, they were gone.

"Hmmm …," said the smart fellows in Beijing, who thought that weakening the currency was a good idea. "Perhaps we should go the other way again."

They promptly did, the yuan strengthened once more, the speculators came back, and now the preliminary figures for 2013 show that capital flows turned positive again, with a net inflow of US$240 billion.

"Good," the smart fellows said last week. "So now we'll try to push it weaker again." And it's my bet that they will once more get exactly what they got in 2012 if they continue of this mind. I don't know if the yo-yo was invented in China, but I have never seen one swung to quite such extremes as this.

The simple fact is that the talk of an offshore yuan market hangs on little more than speculative purchases of yuan. People outside China are happy to take yuan in payment for trade goods only because they hope to turn a profit on the exchange rate. There is otherwise no natural offshore market for yuan.

This in turn says that Beijing will have to pay dearly if it wishes to maintain the illusion of the yuan as an international currency. If it stops pushing the yuan up, the illusion will pop like a soap bubble.

In short, it's just a silly game.