1. NS3040 Fall Term 2015 Chinese Currency Movements: February/March 2014

2. Chinese Currency Movements I Late February 2014 China’s yuan fell steadily against the U.S. dollar Appears the Chinese central bank deliberately pushing the currency lower Why the sudden devaluation? Currently yuan trades within a tight range set by the central bank every day Short-term traders and increasing demand almost constantly pushing currency higher within that range By devaluating the currency’s value the central bank is trying to discourage (one way) speculation on the currency With fewer speculators trading in the yuan China hopes to have an easier path to widen the yuan’s trading range further In longer term make the yuan a free-floating currency 2

3. Chinese Currency Movements II 3

4. Chinese Currency Movements III Why does China want to free its currency in the long term? Having a freely traded currency makes it easier for the yuan to become more prominent in trade and payments internationally A freely convertible currency also makes the yuan a more attractive reserve currency for Central Banks Other reasons – China is trying to push its economy away from relying so much on exports and investment Instead it wants more of its growth to come from domestic demand Making the yuan behave more like a market driven currency fits into this broader plan. 4

5. Chinese Currency Movements IV More conjectural reason: Concerns over shadow banking operations Since December 2012 the People’s Bank of China (PBoC) has tried to limit activities in the shadow banking sector Aim is to prevent high-interest loans from triggering a wave of defaults among local government borrowers Such efforts have not been effective Shadow Loans (entrusted loans) rose to $64.7 billion in January 2014 almost double that in January 2013 Avoiding the central bank’s pressure to liquidate shadow financial assets (which offer attractive returns) banks are opting to sell off lower yielding enterprise bonds (debt issued by state- owned companies) Result – raising cost of financing to companies and local governments. 5

6. Chinese Currency Movements V These actions squeeze the supply of credit to the “real” economy while shadow finance segment is nourished by inflows of capital that slip through holes in the country’s capital account Steps in the yuan carry-trade Borrow abroad at around 1.0% interest Change money into yuan and bring it to mainland There receive 10 to 12% by lending it to a trust or 20% by putting it with an underground bank On top of that capered the expected yuan appreciation Evidence Signs of over-invoicing of exports 44% in survey felt that fake invoicing was on the increase 6

7. Chinese Currency Movements VI Summing up PBoC wants to stifle one way bets on yuan If successful will slow speculative activity and with it destabilizing capital inflows. Bank knows that if it were to try to stop inflow of illegal capital entirely it might trigger a wave of financial defaults it has been trying to avoid in the first place Gradual approach using exchange rate flexibility to generate a market response seems to suit Bank’s objectives for now 7