NS3040 Summer Term 2014 Chinese Currency Movements: February/March 2014

1. NS3040 Summer Term 2014Chinese Currency Movements: February/March 2014

2. Chinese Currency Movements I • Late February 2014 China’s yuan fell steadily against the U.S. dollar • Appears the Chinese central bank deliberately pushing the currency lower • Why the sudden devaluation? • Currently yuan trades within a tight range set by the central bank every day • Short-term traders and increasing demand almost constantly pushing currency higher within that range • By devaluating the currency’s value the central bank is trying to discourage (one way) speculation on the currency • With fewer speculators trading in the yuan China hopes to have an easier path to widen the yuan’s trading range further • In longer term make the yuan a free-floating currency

3. Chinese Currency Movements II

4. Chinese Currency Movements III • Why does China want to free its currency in the long term? • Having a freely traded currency makes it easier for the yuan to become more prominent in trade and payments internationally • A freely convertible currency also makes the yuan a more attractive reserve currency for Central Banks • Other reasons – • China is trying to push its economy away from relying so much on exports and investment • Instead it wants more of its growth to come from domestic demand • Making the yuan behave more like a market driven currency fits into this broader plan.

5. Chinese Currency Movements IV • More conjectural reason: • Concerns over shadow banking operations • Since December 2012 the People’s Bank of China (PBoC) has tried to limit activities in the shadow banking sector • Aim is to prevent high-interest loans from triggering a wave of defaults among local government borrowers • Such efforts have not been effective • Entrusted loans rose to $64.7 billion in January 2014 almost double that in January 2013 • Avoiding the central bank’s pressure to liquidate shadow financial assets (which offer attractive returns) banks are opting to sell off lower yielding enterprise bonds (debt issued by state-owned companies) • Result – cost of financing to companies and local governments.

6. Chinese Currency Movements V • These actions squeeze the supply of credit to the “real” economy while shadow finance segment is nourished by inflows of capital that slip through holes in the country’s capital account • Steps in the yuan carry-trade • Borrow abroad at around 1.0% interest • Change money into yuan and bring it to mainland • There receive 10 to 12% by lending it to a trust or • 20% by putting it with an underground bank • On top of that capered the expected yuan appreciation • Evidence • Signs of over-invoicing of exports • 44% in survey felt that fake invoicing was on the increase

7. Chinese Currency Movements VI Summing up • PBoC wants to stifle one way bets on yuan • If successful will slow speculative activity and with it destabilizing capital inflows. • Bank knows that if it were to try to stop inflow of illegal capital entirely it might trigger a wave of financial defaults it has been trying to avoid in the first place • Gradual approach using exchange rate flexibility to generate a market response seems to suit Bank’s objectives for now