As China’s Stock Market Boils, Yuan Will Stay Cool

Jul 30, 2015

A weaker yuan may make economic sense, but Beijing can hardly afford a bout of currency weakness now

Those hoping for some action in the Chinese currency markets are going to have to wait, now that the stock market is going haywire again. Beijing can hardly afford a bout of currency weakness on top of everything else that is going on.

That hasn’t stopped some currency traders from betting renewed volatility in the yuan is coming. Beijing, which heavily manages the currency, has kept it almost perfectly pegged at around 6.2 yuan per dollar since April. Offshore markets, however, have lately priced in more future depreciation for the yuan. On Monday, when stocks plunged, one-year forwards implied that the dollar would strengthen against the yuan’s daily fixing rate by close to 3%, compared with 2% last week.

One school of thought goes, if China can’t control the stock market, then why believe it can withstand the pressure of propping up the currency? A more possible scenario is that authorities remain very much in control of the currency, but facing a sputtering economy, decide to let it weaken to boost growth. After all, by staying pegged to the strong dollar, the yuan has appreciated greatly versus the currencies of trade partners and manufacturing rivals in Europe, Japan, Korea and Southeast Asia.

On Friday, there was a hint China’s posture on the currency could change when the State Council, or China’s cabinet, implied a widening of the currency’s state-dictated daily trading band was in the offing. This would mostly be a symbolic act, but past instances of band widening have been accompanied by increased volatility for the currency, and thus more trading opportunities for investors.

Since that statement, however, the calm in stocks has disappeared, making it a risky time to fiddle with the exchange rate.

The policy case for yuan weakness has some merit, but such a move seems unlikely for now. For one, China wants to project currency stability in the lead up to the International Monetary Fund’s decision—possibly later this year—over whether to include the yuan in its official basket of currencies, known as special drawing rights. More importantly, currency weakness on top of stock market declines could accelerate outflows of cash from the economy.

With the stock market unsettled, China can only withstand one pot boiling over at a time.

Source: wsj.com