As the shift in China’s currency policy rattles global investors, you may be wondering how the yuan market works. Here are the basics:
1. What is the yuan?
The renminbi, meaning the people’s currency and abbreviated RMB, is the official name for China’s exchange rate, while the yuan is the unit people use on a daily basis -- like referring to the dollar or the euro.
2. What is a peg?
A peg refers to a fixed-rate currency regime. The yuan was fixed at about 8.3 per dollar until 2005 when the central bank abandoned the link and allowed it to appreciate in a controlled way, known as crawling peg. The authorities re-pegged to the dollar during the global financial crisis in 2008 and 2009 to maintain stability. It then resumed the appreciation in 2010.
3. What is a reference rate?
The People’s Bank of China announces the official exchange rate each morning in a process known as the fixing or reference rate. By selling and buying dollars in the open market, the central bank ensures the yuan trades within 2 percent above or below the official rate.
4. Why is there an onshore and offshore rate?
Policy makers used to tightly control capital flows, allowing the yuan to trade mainly in the domestic market, where they can influence the exchange rate. In 2010, the government started offshore trading in Hong Kong, where the exchange rate is determined by supply and demand, aiming to promote the yuan as a global currency. The ultimate goal is to unite the two markets as the yuan becomes a fully free-traded currency.
Overseas, where the yuan goes by the abbreviation CNH, it’s freely exchangeable, although it tends to track the onshore rate, or CNY, closely. The CNH traded at a 2.6 percent discount to the CNY Wednesday, the widest gap since the offshore market started five years ago, reflecting foreign traders’ expectations of further depreciation.
5. What are non-deliverable forwards?
There’s also a market for non-deliverable forwards, or NDFs. These are agreements in which investors can bet on or hedge against swings in the currency. Before the emergence of the offshore market, the contracts were the main instrument for overseas investors to bet on the yuan, as China’s capital controls limit currency transactions.
In NDFs, parties agree to buy or sell the yuan at a pre-determined rate in the future. At maturity, profits or losses are netted by calculating the difference between the NDF rate agreed upon and the market rate at the time. Since the NDF contracts are settled in dollars, they allow investors to bet on the yuan without actually exchanging the currency.
6. What has changed?
On Tuesday, the central bank shocked global investors by allowing the onshore fixing to drop by 1.9 percent, triggering the biggest one-day decline since 1994. Policy makers said they are changing the way they use the fixing process to give the market force and sway in determining the exchange rate.
While the move signals another step toward making the yuan a freely traded currency, it also raises concern that the Chinese authorities are allowing the exchange rate to weaken in a bid to boost exports. That may trigger competitive devaluations across the world. It’s unclear whether the yuan’s depreciation will continue, but the regime shift has changed it from a stable currency to a more volatile one, a natural consequence of a market-determined exchange rate.