What's China Seeking With Yuan Trading Band?

by: Carlos X. Alexandre

The announcement that China will allow the yuan to trade in a wider daily band - 1% vs. 0.5% - was painted as a good faith effort by the People's Bank of China to relax its control on currency exchange, as reported by Bloomberg.

Chinese officials pledged in a five-year plan running through 2015 to keep loosening controls on currency flows as Premier Wen Jiabao targets higher domestic consumption and an enlarged global role for the yuan that would curb the dollar's dominance.

IMF's Managing Director Christine Lagarde praised the move as well, according to Market News.

"I would like to welcome this important step by the People's Bank of China to increase the flexibility of their currency. This underlines China's commitment to rebalance its economy toward domestic consumption and allow market forces to play a greater role in determining the level of the exchange rate."

And then there were those that saw the new band as proof that the so called "hard landing" will not take place, courtesy of Reuters, although I don't see the connection.

"For everybody who thought China was heading for a hard landing, it's over. This move says they are comfortable with the direction the economy is moving in," Paul Markowski, president of New York-based MES Advisers and a long-time investment adviser to China's monetary authorities, told Reuters.

Finally, White House adviser Ben Rhodes also welcomed the Chinese "openness," according to Reuters.

"It comes in the continuum of us wanting to see the Chinese take more of these steps to see their currency appreciate to come in line with market value," Rhodes said. "They've made some progress. We'd like to see more movement."

Considering that China set the daily reference rate to the highest level as recently as last month, one can see how a wider band could lead to a stronger yuan, as depicted by the chart below, courtesy of China Daily.

(Click to enlarge)

However, any monetary action taken by any nation is always self-serving, and China is no different. In addition, China resisted the appreciation of the yuan while we enjoyed a healthy global economic environment, and the chart above shows how the reference rate - the value that truly matters, not the trading band - was reduced in the weeks leading up to the lower than expected GDP number of 8.1%, and the trading band announcement.

The observation by Joseph Stiglitz runs counter to the broad consensus that China is caving in to pressure to make the yuan convertible, according to Bloomberg, and by implication, open the door to the much desired appreciation.

"Opening up the band in conjunction with other actions they've taken may lead to a fall in the exchange rate rather than appreciation," he said yesterday in Berlin, where he's attending an economics conference. "To the extent they do open up, money may leave and that will weaken their currency. A free market exchange rate may not go in the way the U.S. thinks it should."

And while most observers simply yawned and didn't derive any meaningful impact from China's currency "adjustment," there was yet another important observation which is in line with self-serving tactics, as reported by MarketWatch.

"The official line is that the march toward liberalization goes on. Recently though, there has been more rather than less reserve accumulation in Beijing again, and the subplot must be that there is less desire as the economy slows, for the currency to go on appreciating," said Kit Juckes, head of foreign exchange at Société Générale.

Then on the first trading day after after the band widening announcement, the yuan depreciated as reported by Reuters.

The People's Bank of China weakened its daily fixing for the yuan by 0.13% to 6.2960 per dollar after doubling the limit of the currency's moves to 1% from the reference rate. The yuan fell to as much as 0.46% versus the fixing, not making use of the new limit.

Ultimately the reality on the ground is that China is economically bleeding, but the government must save face internationally and domestically, and Premier Wen Jiabao's "prediction" that GDP will ease to 7.5% is part of the script to gradually depreciate the yuan, not appreciate, while communicating to its people that China is economically fine. Meanwhile, a wider band will provide the opportunity for volatility to show that the yuan's direction, as "dictated" by the markets, is down, not up, and yesterday's seemingly unrelated and unexpected rate reduction of 50 basis points in India, highlights the overall weakness in export dependent nations.

Lastly, Foreign Direct Investment in China registered a year-over-year decline of 2.8%, and while it was the third consecutive negative reading and the first drop since early 2009, the negative trend has been in place for 12 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.