Analysis - China's offshore yuan market spurs FX volatility

Wed Feb 22, 2012 12:17pm EST
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By Gabriel Wildau

SHANGHAI (Reuters) - After two years of promoting greater international use of the yuan, China has a currency -- like it or not -- that is influenced more than ever by the fickleness of global markets.

When the yuan exchange rate hit limit-down for 10 straight days in early December, many analysts saw evidence that "hot money" was fleeing China amid fears of a hard landing in the world's second-largest economy.

But beyond the short-term panic, the yuan's brush with depreciation exposed how reforms intended to promote yuan trade settlement have created new ways for firms involved in trade to skirt the country's strict capital controls. This has exposed the onshore forex market to more dramatic ebbs and flows.

"The episode may have signaled a permanent change in the pattern of the exchange rate's movement," Yu Yongding, a former member of the People's Bank of China's (PBOC) monetary policy committee, wrote in a recent op-ed on Project Syndicate, a website for commentary on global economics and finance.

Speculators can't easily "short China," thanks to capital controls that create major obstacles. Still, trading firms can piggyback on pessimism because of how policy changes have affected foreign-exchange flows and the exchange-rate.

In particular, the rise of the offshore yuan (CNH) market in Hong Kong has enabled corporations involved in trade, which are allowed to move money into and out of mainland China more easily, to arbitrage the spread between the onshore and offshore yuan exchange rates.

The result is that China's forex flows have become more volatile, as capital controls are less able to blunt the effect of international forces.

The buildup of forex reserves is now an increasingly imperfect gauge of demand for Chinese goods and services, as well as foreign investment in China's economy. More than before, data can be misinterpreted.   Continued...

One-hundred Yuan notes are seen in this picture illustration in Beijing March 22, 2011. REUTERS/Jason Lee