China’s flexible in how it deals with yuan value

This article appeared originally in Gulf News: link to original article

Will China ever float its yuan? Officially, there is no peg to the US dollar. However, the People’s Bank of China (PBOC) maintains the value of the yuan within a certain upper and lower limit — in a 2 per cent range broadly — utilising in the process a few monetary tools.
The article here will explain why the yuan won’t be floated anytime soon, and how the PBOC uses it various monetary tools to support the yuan.
Enter fixing mechanism. PBOC recently decided to include a “counter-cyclical adjustment factor”, which basically allows it to re-adjust the rates regardless of the last close, or what the markets decide as the fair exchange rate for the yuan.
Put differently, PBOC sets the rate and defends it. The end result in determining the exchange rate for the yuan is the same, but the mechanism used to achieve it is different since the International Monetary Fund (IMF) included the yuan in its Special Drawing Rights basket — this kind of means that the yuan will have to be floated sooner or later to be at par with all other major currencies in the basket.
Now, how does the PBOC maintain the fixed rates that it desires?
The first tool — and the straightforward one — is withdrawing from the vast amounts of foreign currencies that China holds — north of $3 trillion (Dh11.02 trillion). So what happens when the yuan value drops too much?
PBOC, through banks, will purchase yuan from the market to pump up the price. And in parallel, there are capital controls limiting foreign currencies outflows — Chinese individuals have figured out ways, through different platforms and apps, to move cash out and invest it in real estate.
This led to higher real estate prices in different cities, Vancouver being one example. This tool is also linked to what China does with its income in foreign currencies from different exporting sectors.
The inflow of foreign currencies would heat up the Chinese economy, with increasing pressure to print additional yuans and circulate them in the economy. Instead, one would note that the foreign currencies reserve has hovered about the same levels for the past five years.
The second tool has to do with interest rates. In comparison to the United States’ 1 per cent interest rate, interest rate in China is higher than 4 per cent. This allows ample maneuver space in adjusting the rate upward to attract foreign currencies and support the yuan’s value upwards. Vice versa, lowering the same interest rate will be a direct devaluation of the yuan.
The third tool is that of banks reserve ratio requirements. If the yuan value drops, PBOC would increase its reserve ratio requirements to curb money supply in the economy. The lower supply would push the yuan’s value upwards into more favorable terrain.
The latter tool has been applied the other way around also, with the PBOC cutting its reserve ratio requirements to pump more yuan into the economy — one measure taken to support companies indirectly known commonly as liquidity injection. It must be noted here that this only adds to an ever increasing corporate debt in China, which resulted in Moody’s downgrading China’s rating, the first since 1989.
When there is a high inflow of US dollars into the Chinese economy, the PBOC needs to print additional yuans, which will drive inflation upwards and dilute its value – enhancing the export position but worsening the debt scenario. Therefore, China takes those dollars and invests them in purchasing treasuries and other US debt instruments — the amount is around $1 trillion.
By doing so, China speculates higher demand for US dollars, which subsequently raises the dollar’s value. The case is, however, more complex than what was explained.
What will be interesting to watch is how far the yuan will be manipulated in relation to Chinese domestic debt. The last question that I want to leave you with: what trajectory will the yuan take if floated? (Hint: trade surplus).