BEIJING: For so long a thorn in the side of China's trade partners, the yuan now appears to be not only China's currency but China's problem too.
Driven by fears of a bumpy economic landing, the yuan is now clearly in a two-way market, being roughly flat over the past year against the dollar and with forward delivery markets discounting a loss in the coming 12 months.
This has radically changed psychology about the yuan, both in China and abroad, and has greatly complicated the job of the People's Bank of China of mitigating the impact of the global softening in economic growth.
For years, starting in 2005, the yuan was one of the surest things in financial markets, marching seemingly ever upwards against the dollar after China allowed it to begin appreciating after keeping it artificially cheap. That rise was driven by fundamentals -- strong growth in exports and foreign direct investment, as well as by the psychology that always attends hot assets.
That has clearly changed, and the change, once struck, poses problems for easing the impact on China of its slowdown. It may also, if it lasts, fundamentally recast global financial market patterns.
China's second-quarter balance of payments recorded a net outflow of $71 billion in the capital and financial accounts, against a near $60 billion inflow in the current account. Export growth, for so long booming, is now flagging, with June showing only a small increase on the year before.
That means slower growth in the PBOC's reserves, which are growing at about a 2.5 percent clip, and which even conceivably could begin to shrink. On top of this, individuals and corporations are now less eager to turn their dollar earnings immediately into yuan, understandably given the outlook. If that trend takes root China and the rest of the world could be looking at an extended bout of yuan weakening, something that would heighten trade tensions. While the PBOC may use some of its reserves to smooth or reverse yuan declines — indeed it may already have — it is hard to see it committing to that fight if it turns serious.
Also, as reserve growth is de facto monetary stimulation, any fall in the PBOC balance sheet, driven by hot money flow or any other source, would come at a bad time, tightening just as China grapples with what is, for it, a very hard landing.
This also makes it much tougher for China to cut interest rates in order to stimulate its economy. Lower rates may only make the yuan less attractive to currency holders and could speed capital flight, starting a vicious cycle. This marks a big change for Chinese authorities, limiting their scope of action just when they may be most in need of tools.
To be sure, the impact of a weakening or even two-way yuan is mixed, with costs and benefits strewn around the world. Trade partners won't welcome it, especially at a time of generalized fierce competition for exports as China's main competitors seek to earn their way out of their accumulated debts.
Longer term, if this causes China to do less to direct its economy toward capital investments and exports that's a benefit; allowing consumption to grow and the economy to rebalance. A benefit, however, with a painful transitional period and fierce advocates of the opposite course.
One other side point — if a weakening yuan becomes a problem for China the clock will immediately be set back for those waiting for a liberalization of capital markets. If opening the capital account means a rush of money out of the country rather than in, we'll have to wait for different conditions to see that shiny new financial sector develop.
There are also interesting, but uncertain, implications for Treasuries. China added just $300 million to its $1.16 trillion holdings of Treasuries in June and may by year's end fall behind Japan as the US's largest creditor. While clearly the diminution of demand hasn't hurt Treasuries, which are strongly bid by investors and central banks, any time you see a major client of a financial asset potentially turn into a seller you have a risk.
As for Chinese policy management, the PBOC has plenty of options, though some may be unpalatable: it could, like the Fed, buy assets, or even, like the BoJ, buy assets like equities.
Two formerly fixed points in global markets — a strengthening yuan and strong Chinese demand for Treasuries -- may have changed. Whenever trends that strong reverse, many people will be caught out, having made plans and commitments that confused the persistent with the eternal.
From Sydney house prices to raw material demand, the potential impact is huge and varied.
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— James Saft is a Reuters columnist. The opinions expressed are his own.