After two years of promoting greater international use of the yuan, China has a currency - like it or not - that is influenced more than ever by the fickleness of global markets. When the yuan exchange rate hit limit-down for 10 straight days in early December, many analysts saw evidence that "hot money" was fleeing China amid fears of a hard landing in the world's second-largest economy.
But beyond the short-term panic, the yuan's brush with depreciation exposed how reforms intended to promote yuan trade settlement have created new ways for firms involved in trade to skirt the country's strict capital controls. This has exposed the onshore forex market to more dramatic ebbs and flows. "The episode may have signalled a permanent change in the pattern of the exchange rate's movement," Yu Yongding, a former member of the People's Bank of China's (PBOC) monetary policy committee, wrote in a recent op-ed on Project Syndicate, a website for commentary on global economics and finance.
Speculators can't easily "short China", thanks to capital controls that create major obstacles. Still, trading firms can piggyback on pessimism because of how policy changes have affected foreign-exchange flows and the exchange-rate. In particular, the rise of the offshore yuan (CNH) market in Hong Kong has enabled corporations involved in trade, which are allowed to move money into and out of mainland China more easily, to arbitrage the spread between the onshore and offshore yuan exchange rates.
The result is that China's forex flows have become more volatile, as capital controls are less able to blunt the effect of international forces. The buildup of forex reserves is now an increasingly imperfect gauge of demand for Chinese goods and services, as well as foreign investment in China's economy. More than before, data can be misinterpreted. Dollars once sold to China's central bank may now be sold into the offshore market, reducing forex buildup, even when demand for yuan remains high. Alternatively, dollars once bought from the central bank in exchange for yuan may now be bought offshore, adding to net forex accumulation onshore, even if overall demand for yuan is steady or decreasing.
OPPORTUNISTIC HEDGING The increased volatility will also create additional pressure on the PBOC to further loosen its grip on China's exchange rate by widening the yuan's daily trading band, since a wider band would require fewer and less significant market interventions to maintain. For most of the period since CNH began trading actively in late 2010, offshore yuan has traded at a premium to the onshore spot rate.
For Chinese importers, who are net dollar buyers, this premium created an incentive to shift their dollar purchases offshore, where the same amount of yuan bought more dollars. The effect of this offshore premium most likely supported China's buildup of forex reserves for the first three quarters of last year.
China's reserves grew by $270 billion in that period, 16 percent greater than the same period in 2010, despite the fact that China's trade surplus during that period contracted from 2010. While possible shifts in mark-to-market valuations of China's reserves make any such calculation imprecise, that suggests that other factors, such as the rise in offshore dollar purchases by corporates, may have been partly behind the unexplained rise in reserves.
ONSHORE MARKET FEELS THE HEAT But in September last year, the offshore rate swung to a discount, as heightened concerns about Europe's debt crisis and slowing global growth led to a flight to safety. The emergence of a CNH discount reversed the incentives. Now it was exporters - who sell dollars received from foreign customers in order to pay costs in their home currency - who faced an incentive to shift their transactions offshore.
With fewer exporters selling dollars to the PBOC onshore, that contributed to China's foreign exchange reserves decreasing by $21 billion in the fourth quarter, the first quarterly decline since China began publishing monthly figures in 1999. The trend of exporters buying CNH and then transferring the funds back onshore also helps explain the decline in CNH deposits in Hong Kong in January, when they fell by 589 billion yuan.
The reversal of the CNH spread had a dramatic impact in China's onshore interbank forex market. Even as China ran a trade surplus of $48 billion in the fourth quarter last year, spot yuan traded weaker than the central bank's midpoint fixing almost every day. The yuan hit the lower end of its daily trading band for the first time in 2011 on September 29. At the time, traders said dollar sellers were nowhere to be found.
The PBOC reacted with a series of strong midpoint fixings, in an apparent attempt to signal to the market that it would not let the yuan depreciate. But when market pressure continued to push the yuan weaker, the PBOC on December 16 deployed the heavy artillery, flooding the market with dollars channeled through state banks.
INFLOWS TO RETURN? With fears of a hard landing in the Chinese economy now having largely receded, CNH is now again trading at a premium to the onshore spot rate, potentially indicating the return of capital inflows in the first quarter. For now, such arbitrage remains largely the domain of firms with the documentation to prove they are involved in actual trade, as these are given more leeway for shifting around money.
An exporter who wants to buy offshore yuan can simply instruct its customer to direct payment to its Hong Kong bank. An importer who wants to access the market may conduct a trade transaction with a Hong Kong subsidiary. For financial investors, executing a similar strategy is trickier, since China's strict capital controls are designed specifically to prevent such speculation. Yet some analysts believe such arbitrage is occurring.