The yuan is falling, but only because Beijing wants it to
Despite talk of a greater role for market forces, the currency is still far from freely floating with constant interventions from the central bank
It is hard to fathom quite why so many people have been surprised by the recent fall in the value of the yuan.
Over the past couple of weeks, the mainland currency has fallen 1.3 per cent against the US dollar.
That might not sound like much, but for the yuan it is the most abrupt decline since its 1993 devaluation, and it confounded legions of analysts and investors who had confidently expected the currency's strengthening trend to continue uninterrupted.
Their confidence was misplaced. Despite all the talk about internationalisation and a greater role for market forces, the yuan remains neither fully convertible nor freely floating.
The central bank continues to steer all the currency's movements. Each morning it dictates a daily reference rate, and if necessary, it intervenes heavily in the onshore market to make sure the yuan strays no further than 1 per cent either side of that rate.
And while the yuan has appreciated more or less steadily ever since mid-2010, when the People's Bank of China readopted its crawling peg after a two-year hiatus, Beijing has long signalled that the currency should not be considered a simple one-way bet.
The frequency and volume of those signals have been increasing lately. "Anyone currently considering buying yuan in expectation of even more appreciation might like to think again," Monitor warned on February 10. "It may be primed for a fall."
So when the currency duly began to slump just one week later, we can be certain that the mainland authorities were behind the move.
The reasons Beijing would like to see the yuan fall are clear enough. Yuan interest rates may be modest. But returns in the onshore market, especially in the mainland's shadow financial system, are considerably higher than on major currencies like the yen or the dollar in the international markets.
With many investors confident of making additional exchange rate gains on the yuan, hot money has been pouring into the mainland over recent months.
During January alone, companies and households in the onshore market sold enough foreign currency to buy an astonishing 460 billion yuan (HK$582 billion).
To put the size of that flow into perspective, at the end of last year the entire stock of yuan-denominated deposits in Hong Kong's offshore market only came to 860 billion yuan.
Handling such big flows causes problems for the PBOC. It can intervene in sufficient volume to prevent the yuan from appreciating under the pressure of the inflows.
But if it does, it will continue to accumulate foreign-currency assets like US Treasury bonds, which typically yield less than the short-term bills it sells to finance its purchases. In short, intervening is costly.
Alternatively, the central bank can allow the yuan to continue appreciating. But that attracts even more inflows.
What's more, since mid-2011 the yuan has already gained by about 20 per cent against a trade-weighted basket of currencies.
With many other emerging-market currencies now looking soft against the dollar, any further yuan appreciation will threaten severely to erode the price competitiveness of Chinese exports compared with those of other Asian countries.
So in an attempt to create a sense of two-way risk and deter further inflows, the authorities decided to manipulate the yuan lower on the domestic foreign-exchange market.
For the time being, they have succeeded. Last week's fall triggered a flurry of hedging by mainland importers and position liquidation by yuan speculators that added to the momentum of the currency's decline. Just don't be fooled into thinking this is a freely floating exchange rate driven by real market forces.
The yuan goes where Beijing wants it to, and despite all the talk of market reform, that's not going to change any time soon.