Beijing has served notice that speculation in the Chinese currency is no longer a one-way bet. The market is coming to terms with the fact that a sharp depreciation of the yuan in recent days, including the biggest intra-day fall since 2007 yesterday, is policy-driven ahead of an anticipated widening of the unit's daily trading range. As a result, the yuan was the worst performing currency in emerging Asia last month rather than the most attractive carry-trade bet, with the drop offshore forcing many investors to close out positions at a loss.
That does not signal a long-term trend. Rather, it is the authorities' way of saying the yuan is now a two-way trade and is consistent with their wish for market forces to play a bigger role in setting the price of the currency. In carry trades, investors borrow offshore at low interest rates to buy assets in countries with higher returns and low volatility. The sudden depreciation of the yuan has introduced volatility following a steady appreciation.
Given the rapid rise of overall debt in the economy, further appreciation of a currency that may already be overvalued relative to the currencies of trading partners is potentially damaging. In a sense, the yuan policy over most of the last decade has reached its use-by date. It has been the principal instrument driving financial reform since the currency was revalued in 2005. As the People's Bank of China has allowed the currency to appreciate incrementally, industry has had to become more efficient. A 30 per cent-plus appreciation over time has compelled exporters to move up the value chain.
Now, having squeezed credit domestically, the central bank is using the yuan to remind companies that have borrowed offshore that their costs could go through the roof if the currency moves down. There is a sense that currency weakening paves the way for a widening of the yuan trading band - perhaps after the National People's Congress, which opens next week.
The question is whether a wider trading band and two-way betting on the currency allows a shift to an exchange rate related to a properly managed basket of currencies. The central bank has probably done as much as it can with the currency. Now it has to turn its attention to interest rates and seek more stability in interbank rates as an instrument of the availability and pricing of credit. Such reforms may appear incremental. But if they expose companies to more market forces and prompt them to better manage risk they are to be welcomed.