Currently, China's domestic, "onshore" currency (CNY) does not float freely against other currencies. The CNY exchange rate is pegged to the U.S. dollar with a fluctuation band of plus/minus 2 percent. The centre of the band is reset each day by the PBoC, which buys and sells currencies to maintain CNY exchange rates within the band.
As part of China’s efforts to internationalise its currency, an “offshore” yuan (CNH) was introduced, traded by the Bank of China through Hong Kong. CNH exchange rates float freely against other world currencies. Observers can see the extent to which Chinese officials control the currency environment by following the difference between the CNY and CNH exchange rates.1
Government Controls On Currency Exchange Rates
Many analysts believe that China maintains the CNY at too low an exchange rate to benefit Chinese exporters at the expense of exporters from other countries. But in the past year, the opposite has been observed: the CNY’s real effective exchange rate (REER) has risen by 13%, and the midpoint of the CNY trading band has been persistently above the CNH rate. In a statement at the time of the August 2015 devaluation, the PBoC explained that the central bank fixing point was nearly 2 percent above the offshore exchange rate and needed to be brought back into line.2
The PBoC said that in the future, the daily fix would take account of market currency rates. If true, such an adjustment would narrow the gap between the CNY and the CNH, possibly making further sharp devaluations unnecessary. But according to Khoon Goh, a Singapore-based strategist at ANZ Banking Group quoted in Bloomberg, "the one-off devaluation of the fix and allowing more market-based determination takes us into a new currency regime".3
As the CNY and the CNH move closer together, the need for a separate offshore currency could slowly decline. At the time the Chinese government devalued the currency, it was with the hope that liberalising the CNY would enable it to be included in the International Monetary Fund’s (IMF's) SDR “basket” of currencies, and eventually become a global reserve currency. And in fact, the IMF announced just that in December 2015: the CNY joined the British pound sterling, U.S. dollar, Japanese yen and euro in the IMF’s SDR basket.4
However, many analysts believe that liberalising the CNY will mean further devaluation down the road, and that authorities could also tighten capital controls.
What Does This Means For Business?
Businesses exporting to China could see terms of trade worsen if CNY falls. Conversely, businesses importing goods and services from China may benefit from a falling CNY.
Currency fluctuations are a common risk for businesses in the import and export industry. Forward Contracts can help businesses manage their foreign exchange risk. Forward Contracts are agreements between businesses and foreign exchange providers to buy or sell foreign currency at a fixed rate of exchange on a future date. They allow businesses to lock in an exchange rate now to avoid currency fluctuations and gain flexibility when business circumstances change.
The Takeaway:
Transacting across borders presents a range of risks, not least of which is tackling the volatile world of foreign exchange rates. Read about the day the world got its first taste of FX volatility here. And watch this short video for a look at the key indicators you need to be aware of and when to watch for them.
Sources
- Assessing the CNH-CNY pricing differential: role of fundamentals, contagion, and policy, Bank for International Settlements; http://www.bis.org/publ/work492.pdf
- “China Joins The Global Devaluation Party”, Forbes; http://www.forbes.com/sites/francescoppola/2015/08/11/china-joins-the-global-devaluation-party/
- “China Rattles Markets With Yuan Devaluation”, Bloomberg News; http://www.bloomberg.com/news/articles/2015-08-11/china-weakens-yuan-reference-rate-by-record-1-9-amid-slowdown
- “IMF Survey : Chinese Renminbi to Be Included in IMF’s Special Drawing Right Basket”, International Monetary Fund; http://www.imf.org/external/pubs/ft/survey/so/2015/new120115a.htm
