China’s yuan in spotlight amid key economic data releases this week

The spotlight in the foreign exchange market has fallen on whether Chinese authorities will allow its partially convertible currency to depreciate below the psychologically important level of 7 to the US dollar, a level that it has not breached since the global financial crisis a decade ago.

The yuan fell as low as 6.9714 against the greenback on Tuesday, its weakest level since May, before paring losses to trade little changed at 6.9598. Short-selling activities picked up and expectations are rising that the currency will continue its march towards the 7.00 threshold in the coming weeks or months.

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Market talk is focused on whether Chinese authorities would take action to prevent the yuan from falling below the 7 level, or continue to tolerate a gradual currency depreciation, especially if the move is in line with declines made by other Asian currencies in response to a stronger US dollar.

Sceptics are worried that a sharp fall below the 7 level could signal significant deterioration of US-China trade talks and business confidence as well as a significant increase in capital outflow pressure.

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On the other hand, continued resistance to yuan depreciation pressure by Chinese authorities could actually risk the acceleration of capital outflows over time and would be a setback to the gradual process over the last several years of liberalising of the currency, Goldman Sachs argued in a recent research note.

“The more the authorities seem to insist on holding USD/CNY below a specific level, the more likely that market participants, non-financial businesses, and households would interpret that as a policy ‘red line’ and the less ready they may become for any actual break of that level,” Goldman said.

“This in turn would ultimately make it harder for the authorities to let such a break happen, in an effectively self-fulfilling way.”

Since August, the People’s Bank of China (PBOC) has periodically used moral suasion, administrative or policy measures to slow the pace of yuan depreciation, catching short-sellers wrong footed. But it nonetheless allowed a gradual decline of the currency that it deems as relatively stable.

It reintroduced the countercyclical factor into the methodology of calculating the yuan’s daily reference rate. It also made it more costly to short – or bet against – the currency. It also said it was ready to issue short-term yuan-denominated securities in Hong Kong, which would result in a withdrawal of funds from the banking system. The tighter yuan liquidity would have the effect of supporting the value of the currency.

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Those measures, along with tightened capital controls that have been in place since 2015, have greatly enhanced the PBOC’s capabilities and policy toolbox to contain severe currency shocks or fund outflows even if the yuan does break the 7 per dollar mark, analysts said.

On Friday, Pan Gongsheng, Deputy Governor of the PBOC warned against yuan speculators and said the central bank would adopt macro-prudential measures to stabilise market expectations.

“As for those forces trying to short the yuan, we have engaged directly a few years ago and we know each other very well,” Pan said. “I think our memories should still be fresh.”

China was suspected of taking harsh measures last year to ward off capital outflows, with state-owned banks engineering a spike in yuan interbank rates in Hong Kong to raise the cost for traders of borrowing yuan funds to buy dollar-denominated assets, forcing many out of their positions.

The aggressive government intervention succeeded in boosting the value of the yuan by 6.3 per cent against the US dollar in 2017 compared to a decline of 6.4 per cent so far this year. But they also threatened to discourage overseas investors amid efforts to open up its US$9.3 trillion bond market to a broader set of foreign participants.

So far this year, Chinese policymakers have been less interventionist and allowed a weaker currency to help cushion the slowing economy and take some of the sting out of higher US tariffs, although Beijing has rejected talk that it’s deliberately pushing down the yuan to spur exports.

If Chinese economic sentiment data to be released Wednesday shows increasing economic weakness, it could trigger a test of the 7 level.

China’s official October manufacturing purchasing managers’ index (PMI), which is dominated by the sentiment of large, state-owned firms, is forecast to slip to 50.6, according to a median estimate of economists in a Bloomberg survey, which would be the lowest level since February and a decline from 50.8 in September. The Caixin October PMI, which is a better gauge of sentiment from smaller, privately owned firms, is projected to remain stable at 50.0, the dividing line between contraction and expansion in the sector. The export orders component in both releases will be closely monitored for signs of the trade war’s impact.

Fund flows out of the country have picked up modestly as the yuan moved closer to the key 7 per dollar level in October, but remains well below levels seen in late 2015 when the PBOC unexpectedly attempted to reform the exchange rate, sparking sharp, one-way depreciation pressure.

While the US Treasury declined to label China a currency manipulator in its semi-annual currency report this month, it criticised Beijing’s foreign exchange policy going back to 1994. US Treasury Secretary Steven Mnuchin also warned that the US would keep its eye on the yuan exchange rate to make sure that China did not use a devaluation for economic advantage.