China’s just done something rather interesting…
Market attention this week is focused firmly on the US Federal Reserve. Fed chair Janet Yellen is widely expected to announce the first US interest rate rise since 2006.
But on Friday, China’s central bank made an announcement. The China Foreign Exchange Trade System, part of the People’s Bank of China (PBOC), published a new way of valuing the country’s currency, the yuan.
That new way is a trade-weighted index made up of 13 currencies. As well as the major currencies such as the US dollar, the yen and the euro, it gives weight to Asian currencies, including the Thai baht and Hong Kong dollar.
On the surface, this may seem innocuous and largely technical.
For one thing, other central banks publish trade-weighted indexes for their currencies. For another, the People’s Bank of China has made announcements like this before.
But there are good reasons to view Friday’s move as being significant. It’s a symptom of the pressures and strains China is under right now. One of those is a relatively strong currency – a consequence of its peg to the dollar. For years, China was accused (with much justification) of holding its currency down in order to promote exports.
However, China’s currency is no longer undervalued. That’s not my opinion – as of May 2015 that’s the official position of the International Monetary Fund. Indeed, there’s a widespread sense – not least within China itself – that the yuan is now too strong, dragged higher by its peg to the dollar.
China is slowing. Beijing is trying to manage the slowdown, while achieving a transition towards a new economic model driven by household consumption rather than investment in factories.
With the Fed now poised to start raising interest rates, that suggests the dollar could be primed to climb even higher – the last thing China needs for its own currency.
“The Fed is on a kamikaze mission to raise interest rates”, Jim Rickards, author of the bestseller Currency Wars and the geo-macro analyst for our Strategic Intelligence newsletter, told me earlier today. “China refuses to go along for the ride and just jumped out of the cockpit.”
Previously, China had little incentive to see market forces determine the yuan’s value. That’s because, in the era of all-consuming China bullishness (remember that?), the yuan would probably have gone up. That posed a risk to China’s export-led growth model.
Today, the market is more likely to push the yuan lower against the dollar. Indeed, that’s exactly what happened today, as the yuan hit a fresh four-year low following the PBOC’s announcement.
Friday’s move should be viewed alongside what the PBOC did back in August. Back then, it changed the formula for its exchange rate target to give more weight to the previous day’s move.
This was endorsed by the IMF as a step towards letting market forces have more of a say in the yuan’s value (it was, but a very small one).
On Friday, the PBOC sought to draw more attention to the yuan’s exchange rates with currencies other than the dollar.
Now, on both occasions the yuan fell. So it may be tempting to see Friday’s announcement as part of a grand plan to devalue the yuan. Either that, or part of a move towards a more free-floating regime.
However, the picture is more nuanced. For one thing, China’s foreign exchange reserves have fallen to their lowest level since February 2013.
Part of that reflects the lower value of some of those reserves (eg euro reserves). But the dwindling pile is also down to moves to support the yuan by exchanging foreign currency for it.
The PBOC has been fighting to maintain a peg to the dollar, albeit at a lower level. Why would it do that if it wanted shock devaluation?
Why would it care if it was happy for the yuan to float?
It all comes down to China’s desire for stability: “China’s preference is to have a stable exchange rate between the yuan and the dollar”, Jim explains.
China doesn’t want to overthrow the dollar, that’s too disruptive. It wants to share the stage in a kind of dollar-yuan condominium. This would be a return to something like the old Bretton Woods where major exchange rates were fixed.
The problem is that there is no anchor in the system as there was under Bretton Woods. From 1944 to 1971 gold was the anchor. After a period of confusion (1972-1980), the dollar emerged as the anchor from 1981 to 2010. Beginning in 2010, the US abandoned the anchor and launched the currency wars by manipulating the dollar to US advantage.
Jim covers this in much more detail in his book The Big Drop: How To Grow Your Wealth During The Coming Collapse. He also explains how the IMF’s special drawing rights (which it’s just been announced the yuan is to be a part of) spells the downfall of major world currencies, including sterling.
If you haven’t already, make sure you get your free hardback copy here.
So, as with the Bretton Woods fixed exchange rate system, stability was the whole idea behind the yuan-dollar peg.
It still is
Although the peg is showing the strain and has moved this year, it hasn’t gone away.
“China still controls the exchange rate of their currency regardless of small moves toward liberalisation,” adds Jim. “They are using the ‘market based floating’ idea as political cover for a policy of detaching from the dollar.”
Yes, China wants to detach from the dollar. But it doesn’t want the market to manage the process; it wants to do it itself.
August’s move was a way of getting some political air cover for a small, controlled move in the direction China badly needs.
Friday’s move should be seen as a way of downplaying the yuan-dollar rate and staving off a panic – which would put further pressure on China’s reserves.
“China always does what’s best for China,” says Jim. “They don’t care that much about the US, the IMF or the world. But they do care about appearances and if they can look reasonable while serving their own interests, that’s fine with them.”
Ben Traynor
Editor
The Daily Reckoning
Category: Central Banks