Historically, China has gone to great lengths to shield their currency, the yuan, from the global markets. To coincide with this, the Chinese governments have off and on pegged the yuan with the U.S. dollar. Recently China has made some mini-steps to hopefully open up their currency to outside markets. Last month they said that a handful of foreign banks could invest some of the yuan they hold offshore in local Chinese bonds. Another step was that China ended the peg to the dollar in June. Even though this de facto peg was supposedly removed in June, the yuan has only appreciated less than 2% against the dollar. If you look at historical data you can tell that volatility has increased between the two, but barely enough to even notice. Is China holding back a potentially huge export, their currency, for a particular reason? Many believe that the yuan is artificially being kept undervalued. What kind of pressures is this putting on other economies to devalue their currency, as discussed in a previous post in the series?

After an official exchange rate was established for the yuan back in 1994, China kept a tight grip on the flow of capital across its borders. Even as Chinese companies expanded globally, transactions and goods were priced in foreign currency. Why would they do this? Well this allows the authorities to steer the economy and control business. On the other hand however, Chinese companies are exposed to potential foreign-exchange risk among other problems. This has led to a change in approach.

Starting last year, exporters to China can now price their goods in yuan and deposit the proceeds in offshore accounts, mostly in Hong Kong. At first there weren’t enough deposits to make the return worthwhile. However, as the deposits have grown, so has the number of firms taking advantage of this system. Even McDonald’s has gotten in the action by issuing a yuan-based bond in Hong Kong. There are still many stipulations. Yuan can only flow out of China if goods or services flow the other way.

The recent decision to let some banks spend their offshore yuan on local Chinese bonds creates many opportunities as well. This will let some offshore yuan to go back into China in exchange for assets. The onshore bond market is worth $2.9 trillion! This would be great for the Chinese companies because it will let them have an alternative source of borrowing. Chinese officials are still unsure about whether to proceed with opening up the capital flows more. If foreigners sell their dollars to hold yuan, it would put upward pressure on the currency, making it harder to manage or manipulate as some would say.

Many are led to believe that China is keeping the yuan artificially low to give Chinese exports an unfair advantage in international markets. Many believe that this has to be a huge intervention, for the upward market pressure has to be intense. This along with the U.S. dollar depreciation has put immense pressure on other governments to intervene in their own currency. Countries such as Japan may feel like their factories and exports are at risk. On September 15th, Japan intervened in currency markets for the first time in six years to depress the yen’s value, which has been rising.

Some believe these competitive evaluations could derail the recovery. This hurts those emerging markets because their products which are rival to those in Japan and China are becoming less competitive with these devaluations. The cost advantage now wouldn’t be worth the move of factories and capital. Should we be concerned about this global currency war? What should China's policy on the yuan be going forward? Please comment and let us know your thoughts!

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