China's yuan is sliding and market participants suspect authorities are deliberately but slowly engineering a light depreciation of the currency, both to complement an easy monetary policy and to support exports.
Several signals have stirred that speculation. While the yuan has declined roughly 2% this year against the dollar, it has become relatively less competitive as Japan's yen and currencies of other neighbours South Korea, Thailand and Taiwan drop more sharply.
The People's Bank of China (PBOC) also appears to have loosened its grip on the yuan, allowing it to fall to the weak side of the 7.2-per-dollar level that state-owned banks had staunchly defended in the past, though it has continued to lend some support through stronger-than-expected settings of the daily mid-point for the currency.
Last Friday, traders took the absence of state banks in the market to push the yuan to 7.23 to a dollar initially, and even though state banks eventually stepped in the yuan saw its biggest daily drop in nearly 3 months.
Analysts at National Australia Bank (OTC:NABZY) (NAB) said it was "more than coincidental" that the PBOC’s defence of the yuan had relaxed in the same week the Bank of Japan abandoned its negative rates and yield-curve control policy.
Though the BOJ's policy shift last week was momentous, Japanese yields are still barely positive and the yen has ironically weakened further. It is down 7% this year against the dollar this year alone, and at a 30-year low against the yuan.
"Concerns at loss of export competitiveness vis-à-vis Japan too have motivated Friday's decision to lift the 7.20 cap," NAB analysts Ray Attrill and Rodrigo Catril wrote this week.
The yuan's trade-weighted index is up 2% so far this year as currencies of China's trading partners have weakened, gnawing away at the country's export competitiveness and hobbling its uneven economy recovery.
The index is at 99.30, far above the 92-98 band that analysts think the PBOC is comfortable with.
The PBOC did not respond to a Reuters request for comments.
FLOWS AND OTHER FORCES
Even though China's exports seem to have rebounded early this year, the manufacturing sector is struggling, and weak export orders suggest the sector needs more support. A weak yuan would help lift export earnings.
Analysts at Oxford Economics expect the monetary policy divergence between the U.S. Federal Reserve and PBOC to keep the yuan weak in the first half of 2024, but wrote that "any depreciation ahead is likely to be highly controlled", and projected the yuan will not fall beyond 7.34, a level last seen in September.
UBS strategists Rohit Arora and Teck Quan Koh also reckon there could be a shift in Beijing's policy priorities, similar to the yuan's decline in the second half of 2022, when it gradually fell nearly 9% to as far as 7.328.
"Put another way, we don’t expect authorities to allow yuan to be fully market-driven, but continue with a managed and orderly adjustment process," they said.
Barring another big boost for the U.S. dollar, they expect the yuan will head slowly for 7.4.
Indeed, the steady outflows from frail mainland stock markets and other speculative bets might require the PBOC to dampen volatility, as it does normally through state banks.
One such pressure point is the yuan's increasing use in 'carry trades' in which investors borrow in a currency with low interest rates and invest the proceeds in a higher-yielding currency.
Returns on yuan-funded carry trades are lower than that on yen-funded ones, where an easy 5% annualised gain can be made on 3-month swaps. But traders expect the yen to be more volatile under the BOJ's new policy regime, while the yuan has traditionally been sheltered.
"From where I sit, the only thing preventing the yuan from meaningfully weakening is active policy guidance from PBOC," said Rong Ren Goh, a portfolio manager in the fixed income team at Eastspring Investments.
Goh has been using the offshore yuan as a funding currency since the beginning of the year, shorting the currency and investing in high-yielding assets such as Indian rupee bonds.
"If you’ve held a long dollar-CNH position since the beginning of the year, you would have already earned more than 400 pips of carry and capital gains," Goh said.
