Don’t read too much into yuan’s decline

SHENZHEN: The Chinese yuan has fallen by almost 8% against the US dollar since April. This has led many to speculate that China is intentionally trying to devalue its currency to offset the effect of US tariffs. It almost certainly isn’t.

In theory, the price of the yuan is set by a basket of more than 20 currencies, many of which are either pegged to the dollar or managed implicitly against it. So when the dollar goes up, the yuan goes down, and vice versa.

In recent weeks, though, the yuan has been falling quickly. Before the imposition of tariffs, as the dollar was rising, China appeared to be keeping its currency above the level predicted by the basket. But since the trade war started in earnest, it has let the yuan drop rapidly closer to the implied value. That has prompted worries that China might be engaging in competitive devaluation.

A closer look at the numbers should dispel this fear. Since January, the US dollar index has risen 8.5%, while the yuan has fallen only 6.1% against the dollar. In the same period, the MSCI Emerging Markets Currency Index has declined by 6.4% — almost perfectly matching the yuan and suggesting that, if anything, China’s currency needs to fall further to reach the level implied by the basket.

Moreover, even as the yuan declined in the second quarter, China had net settlement inflows of $32 billion. That surplus, combined with a declining currency, further suggests that China is simply pegging the yuan’s value to the basket.

More important, it’s unlikely that China wants a significant and sustained fall in the yuan. That would amount to trading one set of problems for another: consumers and businesses would face a double whammy of price increases due to tariffs and reduced purchasing power due to a weakening currency.

Recent history suggests that China has been trying to limit moves in the yuan once it hits either 6.9 on the lower bound or 6.3 on the upper bound. With the onshore yuan trading at 6.79 and the offshore even weaker — indicating that investors expect a further decline — it’s likely that officials will step in before long.

That’s especially true because things will probably get worse for China’s economy before they get better. A major risk to Chinese finances has always been the path of US monetary policy. With the Federal Reserve signalling more rate increases — thereby likely pushing the dollar up and the yuan down — and US-China bond spreads at less than 1%, the landscape ahead looks increasingly rocky.

The most important thing China can do right now is clarify its intentions. In this regard, China’s central bank could emulate the Fed by communicating better with markets; currently it provides little guidance about its targets.