China has let the yuan depreciate beyond the key level of 7 per dollar, prompting the U.S. Treasury to label it a currency manipulator. This escalation in the U.S.-China trade war has rattled global markets.
The moves have put the spotlight on China’s hybrid financial system, in which the state and the market both play big roles, and left investors and economists wondering how much further Beijing will let the yuan fall. Here’s a look at how the system works.
The Yuan Moves—in a Controlled Way
Most major currencies such as the U.S. dollar, euro and Japanese yen are free floating, meaning markets set their exchange rates minute by minute. Others, like the Hong Kong dollar, are pegged closely in value to another currency. In Hong Kong’s case, it is pegged to the U.S. dollar.
Mainland China used a system like Hong Kong’s until 2005, but today the yuan is somewhere in between. Authorities fix a daily midpoint—based partly on the previous close—and let the onshore yuan trade as much as 2 percentage points above or below this level, intervening to buy and sell the yuan if it rises or falls too far. That caps daily volatility. Analysts say the central bank’s guidelines give it plenty of discretion in setting the yuan’s value.
…And It Trades in Two Markets
The onshore market is under the government’s direct jurisdiction, while the offshore market has no trading band. The offshore yuan is traded mostly in Hong Kong and is also known as CNH. It often reflects where investors believe the onshore yuan, or CNY, will end up.
Borrowing costs differ. When the People’s Bank of China, the central bank, wants to support the yuan without affecting the domestic economy too much, it can raise interest rates offshore, as analysts believe it did last year. That makes it costlier to bet against the currency.
On Tuesday, the PBOC said it would sell yuan-denominated bills in Hong Kong, a move aimed at mopping up funds and removing a source of downward pressure on the offshore yuan.
China Has a Huge War Chest
China owns more than $3 trillion in foreign-exchange reserves, a key tool for currency management. If the yuan is too weak, it can sell U.S. Treasurys or other assets and use the received dollars to buy the Chinese currency, supporting its value.
From mid-2014 to early 2017, those reserves fell by nearly $1 trillion as the PBOC tried to stabilize its currency and as Chinese investors moved money overseas. The country has since cracked down on various kinds of capital flight.
China’s major state-owned banks can also help out—sometimes in indirect ways. Last year, they bought swaps—a roundabout way to bolster the currency without immediately depleting reserves.
The Yuan Has Yet to Go Truly Global
Despite China’s economic heft, its currency makes up just around 2% of cross-border transactions, according to payments firm Swift. That isn’t surprising, given China maintains strict controls on the movement of money in and out of the country.
Still, Beijing has made tentative efforts to internationalize the yuan. In 2016, it joined the International Monetary Fund’s basket of reserve currencies, a milestone in the country’s financial development.
The PBOC nowadays tracks the yuan’s value against various counterparts, which has reduced the role of the dollar in determining its value. But the relationship with the dollar remains crucial, due to the greenback’s central role in global trade.
The Central Bank Has a Different Set of Tools
Many central banks rely heavily on benchmark interest rates, which in turn directly affect currencies, since higher rates draw in capital.
But China’s monetary policy also looks different: Its central bank focuses more on so-called reserve-requirement ratios, a tool rarely deployed elsewhere, which determines how much a bank must hold in reserve at the PBOC relative to its deposits. Higher rates mean less lending. The central bank, which isn’t an independent entity like the Federal Reserve, has done this in part because this ratio is less politically sensitive than moving interest rates.
This setup also means Beijing can attempt to stimulate the economy without pressuring the yuan as much as a traditional interest-rate cut would.
Write to Mike Bird at Mike.Bird@wsj.com and Steven Russolillo at email@example.com
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