Back in 2015, when the US Dollar started its striking ascent as the world began repricing the Fed's upcoming tightening, China - whose currency is pegged to the dollar - had no choice but to gradually, or not so gradually, unpeg the Yuan from the world's best performing currency as otherwise its exports to the rest of the world would plunge. In fact, it was precisely China's tumbling exports (coupled with ongoing import weakness by the EU) which prompted us to correctly predict that China would devalue its currency, just days ahead of Beijing's stunning announcement.
As we said on August 8, 2015, "as global trade continues to disintegrate, and as a desperate China finally joins the global currency war, it will have no choice but to devalue next."
That's precisely what it did.
Now, nearly two years later, China - in addition to a host of other problems - is facing the opposite issue: a dollar, to which it remains pegged, that has been rapidly declining in value, and is now not only at the lowest level since last October, the DXY is almost exactly where it was when China devalued in the summer of 2015. This may explain the surprpsing spike in Chinese currency volatility in recent days, coming after a period of unexpected calm and stability in the Yuan market. While the catalyst may have been last week's Moody's downgrade of China's credit rating, followed by China's decision to once again change its Yuan-fixing mechanism, introducing a "counter-cyclical factor", or a mechanism allowing the PBOC to largely adjust the Yuan rate at will, the surge in the yuan against the dollar has been nothing short of breathtaking, and as we noted earlier today, the Chinese currency just had its biggest 4-day rally against the greenback in 12 years.
There is a fine nuance here: as UBS noted overnight, while the Yuan has strengthened against the USD, it has actually depreciated against the other currencies that make up its basket.
In other words, much of China's move has been to offset the recent dollar weakness - the inverse of the devaluation move from two years ago - and not to depreciate the Yuan against the world. That is a point Beijing has been desperate to make to locals, in order to avoid another spike in capital outflows which marked much of the Yuan "devaluation" period as residents and traders fear another bout in currency volatility. This, in turn, explains the fireworks that have taken place in the offshore yuan market, where between the soaring CNH overnight deposit and interbank rates, and the record surge in CNH Tomorrow Next Forward points, which jumped to an all time high of 290bps overnight, the PBOC has made it very clear it will not tolerate any "speculative move", i.e., selling, i.e., capital outflows, in this post-downgrade transition period.
To be sure, the above is just one possible explanation for Beijing's motivation behind the recent dramatic moves which have kicked Yuan traders out of hibernation on very short notice. There are others, and courtesy of Bloomberg, here are seven theories proposed by various analysts, to explain the Yuan move and what has been going on in China over the past week.
1. Moody’s Shock
China was none too pleased with Moody’s Investors Service’s unexpected credit downgrade, which elicited a stinging rebuke from the finance ministry and a heap of criticism from state media. The yuan has jumped almost 2 percent offshore since the May 24 rating cut, which likely spurred intervention from the authorities and even the changes to the fixing formula, said Jason Daw, head of emerging-market currency strategy at Societe Generale SA.
2. Soothing Markets
Sentiment toward mainland Chinese assets had deteriorated before the Moody’s move, with stock and bond markets whipsawing traders amid Beijing’s deleveraging drive. Bloomberg Intelligence’s Chief Asia Economist Tom Orlik says bolstering the yuan could be part of a broader effort to calm markets amid that crackdown. Also, with a twice-a-decade leadership re-shuffle in the Communist Party due later this year, China’s tolerance for market volatility is low, he said -- the state is moving to “put a floor” under markets.
3. Fed Factor
Orlik’s other theory is that the People’s Bank of China is bolstering the yuan pre-emptively, amid prospects of another interest-rate hike from the Federal Reserve this month. With evidence Chinese growth may have peaked for 2017, the PBOC may not want to follow suit with its own tightening and is instead turning to other means to support the currency. Fiona Lim, senior currency analyst at Malayan Banking Bhd, subscribes to the Fed idea, saying policy makers may be wanting to build more guidance into the yuan to boost market confidence ahead of a prospective dollar rally. The PBOC didn’t immediately respond to faxed questions about the yuan on Wednesday.
4. Price Mismatch
This one’s for the FX nerds and has gained a lot of traction with currency strategists. Concern over the yuan being “consistently weaker” than the fixing rate at the end of the Chinese trading day triggered the changes to the reference rate, according to Gao Qi, a currency strategist at Scotiabank. What the PBOC viewed as irrational depreciation pressure on the yuan was preventing it from achieving a more “fundamentals-based” closing price, said Tim Condon of ING Groep NV. China tweaked the fixing formula - which also incorporates the closing level - to narrow the gap between this price and the reference rate. SocGen’s Daw is also on board with this theory.
“It shows that China may prefer a stronger currency when the dollar weakens,” said Tommy Xie of Oversea-Chinese Banking Corp.
5. No More Weakness
Yuan weakness has been a hot topic since the election of Donald Trump, with the currency’s three-year run of declines spurring claims that China is deliberately sending it lower to make its exports more competitive. While that pressure may have eased, the yuan’s persistent weakness against currencies other than the dollar may be behind the recent bout of strength, said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd.
“The authorities are not satisfied with the yuan merely remaining stable against the dollar,” they want losses versus a 24-currency basket to be arrested too, Goh said.
A “herd mentality” in markets meant there was a bias toward yuan weakness, said Peter Chia Chih Siong of United Overseas Bank Ltd.
6. Lingering Trump Concerns
While the U.S has backed off some of its more strident criticism of China’s currency policy, Nomura Holdings Inc. analysts said in a May 26 note that they noticed a shift in the yuan’s fixing regime from early April, just before Trump met with Chinese President Xi Jinping. The daily rate was coming in stronger than what the analysts who tracked it expected throughout April, fueling speculation of a tweak that was basically confirmed last Friday when the government said they were considering adding the “counter-cyclical adjustment factor” to the fixing formula. U.S. political pressure may be behind China’s quest for a stable yuan, according to Nomura.
7. Belt and Road
China rolled out the blue skies for its Belt and Road summit last month, which saw leaders from around the world descend on Beijing as the government showcased what’s shaping up to be its cornerstone diplomatic initiative. China has been pushing companies to use yuan as part of the global infrastructure spending spree, and the currency is up more than 1 percent onshore since the meeting. Improving the yuan’s prospects and damping market volatility could boost overseas investor appetite for yuan-denominated assets, said Ken Cheung, an Asian currency strategist at Mizuho Bank Ltd. in Hong Kong.