China’s currency has seen a lot of volatility in the past year, but renewed pressure from market expectations as liberalisation continues will likely benefit investors trading in yuan.
The Chinese Central Bank decided in mid-2015 to weaken the peg to the US dollar, leading to a steady devaluation of the yuan. This devaluation was so deep and prolonged that investors worried about the prospect of diminishing growth rates and market expectations forcing the People’s Bank of China (PBoC) to support the yuan by selling foreign-exchange reserves.
Paired with the aim of letting the yuan become part of the IMF’s Special Drawing Rights (SDR), this trend brings market turbulence, but also opportunities for investors as it forces monetary policy to become more transparent.
More liberalisation and market-based constraints in monetary policy can only benefit investors and companies, who want to deal in renminbi. Greater transparency in monetary decision making allows investors to better interpret Chinese official pronouncements.
Meanwhile, market expectations incentivise truthfulness, not least because of the Chinese desire for international recognition for its economic achievements and standards in economic policies. Also, as market pressure adjusts the levels of the yuan, the currency’s official value will get closer to its market-clearing value.
Increased levels of liberalisation will let investors evaluate policy decisions in real-time through demand and supply, meaning that the Chinese government must strengthen the rule of law and reduce arbitrariness in the protection of financial property. All in all, it will improve pricing transparency for customers and reduce currency risk for trading partners.
Self-enforcing transparency through market expectations
According to Swift, the share of the renminbi in global transactions went down to 1.7% in 2016, ranking 6th after the Canadian dollar by about 2%. At its peak in August 2015, the renminbi’s share was very close to the share of the Japanese yen (2.8%), which within a year regained its leading role in the markets of Asia-Pacific.
The decline in significance for global transactions was triggered by the turbulence on the Chinese stock exchange, panicked yuan-purchases by the Central Bank, and recurring concerns about Chinese public debts.
Despite these concerns, the target to internationalise the yuan further remains. Today, more than 1,800 banks clear renminbi-transactions, 12% more than last year. The yuan already surpassed the Swedish crown, Australian dollar and Hong Kong dollar, but to keep up with the five largest currencies and to fulfil market standards to become part of the IMF SDR, internationalisation has to go hand in hand with increased transparency in decision-making.
This includes greater responsiveness to market expectations and reasonable stability-enhancing central banking. Both are necessary to increase investor confidence and make the yuan more attractive. The aim of the PBoC to make the yuan more important globally shrinks its own discretion.
SDR and shrinking margin of manoeuvre
Becoming part of the SDR was a politically desired step with consequences beyond symbolic importance. The decision has put the yuan in the financial world’s spotlight, which makes it more difficult to take arbitrary monetary and fiscal policy decisions.
First, it will require more creativity to explain the decline of the renminbi’s value to stimulate the economy and second, any policy decision will receive greater attention from investors. This in turn will demand ever greater reactions from the PBoC; as markets are now more focused on the yuan, investor reactions will exacerbate the effects of any PBoC decision and increase the amount of resources involved. Consequently, global markets will force the PBoC to make more prudent and cautious decisions.
This is especially true for any kind of governmental obscuration and very painstaking for the PBoC, whose policy decisions, measures and executions rely on secrecy and surprise as evidenced by unannounced and unexpected rate cuts and supporting purchases during the turbulence in early 2016. Now markets will catch any attempts like these sooner, as the SDR brought new attention to governmental actions.
Thus, if currency markets decide that official statements ring untrue, they will bet against the renminbi. After the invitation to join the SDR, the renminbi dropped, and it is still under strong selling pressure. These pressures have only been magnified by the increased attention Beijing has brought upon itself. However, it will enforce more transparent, coherent and investor-friendly policy making.
Market influence on policy-making will benefit investors
China’s domestic equity and bond markets are large and growing fast, but plenty of potential remains, given the size of the economy. Funding is not a problem; the main obstacles to capital market development are the fragmented regulatory framework, insufficient or inconsistent information disclosure, interest rate controls and the absence of a large pool of institutional investors.
The current financial sector reforms are heading towards removing these obstacles, but the PBoC will need to allow for more liberalisation – and thus less arbitrariness – until it reaches full convertibility of the yuan.
It will take some time for the PBoC and the Chinese government to adjust to the new situation in which market expectations strongly influence policy decisions, but the pressure from investors will increase transparency for everyone.