Will a ‘historic’ policy shift lead to a fall in the value of the Chinese yuan?

So, is this a big deal or what?

Over the weekend, Chinese authorities increased the trading band for the yuan (or renminbi) to 2% from 1%, in what Business Insider described as a “historic policy shift”.

Well, perhaps Business Insider was exaggerating a teensy bit, there’s no doubt that the shift is significant.

China’s currency is tightly controlled by the authorities (its value is not fixed in the foreign exchange markets) .The central bank fixes the exchange rate of the currency daily, and the rate can fluctuate 2% higher or lower from the central bank ‘fix’.

The move to widen the trading band seems to be part of a broader economic structural reforms that are aimed at further liberalizing the economy — and in preparation for full convertibility of the yuan.

So, what does the latest move mean for the Chinese yuan?

Two things: one, the authorities believe the currency can handle a little more volatility than earlier, and two, the currency is headed lower in the short term.

On Monday, one US dollar fetched around 6.15 yuan. The yuan has shed nearly 2% against the dollar since the start of this year, mainly as a result of central bank action to change the widespread perception that the yuan is a safe, one-way appreciation bet.

As research reports from Citi, Stanchart and Daiwa suggest, the yuan is now expected to weaken further against the US in the medium term. (Note: The links in the above sentence are not links to the research reports, but to stories that refer to them.)

There are three reasons for this.

One, the ongoing Fed taper will likely reduce the amount of hot money inflows into China, reducing demand for local assets, which should pull down demand  for (and thereby the value of) the yuan.

Two, there are growing signs of trouble in China’s financial sector, exemplified by the country’s first corporate bond default recently. More defaults are likely to follow. Troubles in its shadow banking sector are also intensifying worries about its potential fallout on the broader economy.

Three, high local government debt is another pressure point for the financial sector that will keep investors on edge. That will affect capital inflows/outflows and the value of the yuan.

Overall, these issues highlight the challenges regulators and the government will face as the nation continues on the path of  financial liberalisation.

In addition, a weaker yen will provide a boost to exports and reduce the appetite for imports, just when the Chinese government is attempt to wean the economy from exports and promote local consumption. A sliding yuan could also push up prices of imports, which could stoke inflation within the local economy.

All these problems arise just as the economy is slowing down. Indeed, it will be quite the challenge for the central bank to ensure there isn’t a rush of capital outflows in anticipation of further yuan weakening.

A recent string of weak economic data indicates that China could struggle to meet its 7.5 percent growth target this year, which will be its slowest pace of growth in nearly 25 years.

 The prognosis, for now, isn’t looking so good for China’s economy — or the yuan.

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