Will Lower Interest Rates Weaken the Yuan?

The Central Bank of China surprised everyone with an interest rate cut. This was done in response to a slowing Chinese economy, worrisome real estate bubble and a generally high debt load carried by Chinese companies. The question we raise is will lower interest rates weaken the Yuan? The Taipei Times thinks that was the point. The Times believes that the Central Bank of China wants to soften the Yuan.

China’s surprise interest rate cut is another step toward softening the country’s exchange rate, setting the yuan on course to end the year lower for the first time since its landmark revaluation in 2005.

The People’s Bank of China (PBOC) cut one-year benchmark lending rates on Friday, a move celebrated by Chinese corporations struggling against a toxic combination of high debt load and weak end demand.

Analysts say it could also signal the end of a rally in the yuan since May, especially if the central bank follows up with a cut to reserve requirement ratios, which would flood money markets with cheap yuan.

How long and far lower interest rates weaken the Yuan remain to be seen. China has to deal with the fact that their years of stellar growth are coming to an end. Economists believe that by 2020 China will be happy with a 4% per year growth rate bringing it closer to what is the norm in North America and Europe. Real estate is overpriced in China and the collapse of the real estate bubble could be disastrous. Lowering rates will take pressure off Chinese businesses and make Chinese products cheaper to the world. A weaker Yuan may be what China wants in the end.

A Careful Goldilocks Approach

There is a risk of Forex traders and investors fleeing the Yuan causing significant depreciation of the currency. The Economic Times notes that there is increasing market caution regarding the Yuan.

China’s yuan stuck close to the official guidance rate for a second day on Tuesday as investors weighed how the recent monetary easing might impact the exchange rate. By midday, spot yuan had rebounded from early losses to stand at 6.1405 per dollar, 0.02 per cent stronger than Monday’s close.

The People’s Bank of China (PBOC) fixed the yuan’s daily midpoint at 6.1390 per dollar, up 0.05 per cent from previous day’s fix. Traders and economists believe the PBOC will attempt to preserve general exchange rate stability through the midpoint, to risk setting off a panic depreciation, but the market may be preparing to start consistently pricing the yuan weaker than the midpoint.

The Central Bank of China sets guidance ranges for currency trading in order to maintain a stable market. This is similar to the circuit breaker rules in US stock exchange that simply stop trading if daily movement is excessive. Not too hot, not too cold and just right seems to be the approach of the central bank to avoid excessive weakness of the Yuan at a time when low interest rates are needed to deal with internal Chinese economic issues.

How Weak Might the Yuan Become?

Just how bad could it get if the central bank cannot limit a grand exodus from Yuan holdings? An article in Reuters notes that more volatility could been seen in the Yuan.

Investors have long been attracted to yuan-denominated assets, seen as relatively safe given implicit government guarantees, and at the same time higher yielding than similarly rated dollar-denominated instruments.

These high yields, along with the prospect of forex appreciation, encouraged speculative “hot money” to flow into China, maintaining upward pressure on the exchange rate. Friday’s rate cut now reduces the relative attractiveness of the yuan and makes it more risky to hold going forward.

The weakness of the Yuan coupled with the increasing attractiveness of the US dollar could lead to flight of capital. China is stuck between a rock and a hard place as they have to reduce rates and they cannot let the Yuan slide excessively.