All China's roads lead to a lower renminbi

One of the main topics on the sidelines of the G20 meetings in Sydney at the end of February was why the normally well-behaved renminbi suddenly turned lower in the midst of the proceedings.

In the past two weeks, the Chinese currency has dropped 1.3 per cent.

Prior to that lurch down it has reliably appreciated, especially ahead of international gatherings - a policy in keeping with the Chinese government's long stated goal for the renminbi to become a reserve currency.

The slow rise in the value of the renminbi previously was also meant to implicitly refute charges on the part of certain US Treasury officials and politicians that the value of the renminbi was being artificially driven down to support the Chinese export machine.

Since mid 2011, the Chinese currency has moved up nearly 20 per cent on a trade weighted basis and nearly 10 per cent last year alone, according to data from JPMorgan. How then to explain both the recent drop in value and the timing of that drop in value?

As well as the government's oft-voiced determination to see the renminbi play a greater role in everything from trade flows to the reserves of central banks, there had been plenty of other reasons for optimism for the renminbi's prospects.

Although Beijing maintains ostensibly tight controls on capital account convertibility, people on both sides of the border find ways around them. Last year, fund inflows into China amounted to some $500bn, attracted by a rising renminbi and relatively high interest rates in a world where most central banks (especially in the developed markets) are holding rates close to zero, according to research from ANZ Bank.

In retrospect though, the reversal should not have come as a surprise. Regulators at the People's Bank of China and the State Administration for Foreign Exchange have quietly expressed concern at the hot money inflows for months. They have also let it be known that they wish for the renminbi to be something other than a one way bet. Authorities are likely to soon widen the trading band against the greenback from its current 1 per cent limit which should also make the currency slightly less stable.

One other factor which may well have influenced Beijing though was the intense anger with the Japanese who have driven their currency down 25 per cent on a trade weighted basis under Prime Minister Abe's first policy arrow.

As China moves up the value-added chain, it competes more and more with Japanese goods in third markets. Chinese officials believe it is especially hypocritical of the Americans to support Japan's predatory currency policies. They are not alone in that belief. The Koreans are furious as well. Both wonder for how much longer the Germans will refrain from criticising Japan, since Germany competes even more directly with the Japanese, especially in the market for luxury cars.

Meanwhile, many analysts and hedge fund managers have long asserted that the renminbi is overvalued. They believe that China is in an impossible dilemma: Beijing cannot slow the growth in lending without risking a hard economic landing, but if it fails to rein in lending, it risks both a bubble in property prices and a raft of bad loans on the balance sheets of the banks. Either way, the renminbi should trade at a lower level, in line with these more sober prospects.

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In any case, the sudden change in the direction of the currency was a shock to many other hedge fund managers whose most profitable trade last year was to borrow yen, leverage up that depreciating currency by a factor of five and invest in renminbi. The trade was lucrative both because of a big interest rate differential and gains on the currency. On a risk-adjusted basis, it was even more rewarding because there was so little volatility in the renminbi.

In putting on this trade, macro managers were playing off the two most controlled currencies in Asia, shorting one controlled by a government determined to drive it down - the yen - and going long the currency controlled by a government that wished to see it slowly move up in value - the renminbi. Those dynamics are all changing now.

The message from Beijing may not alter the Japanese stance, but Beijing may still have the last laugh. The yen has stopped depreciating and has in fact strengthened in recent months, despite a record trade deficit.

As the uncertainty facing many emerging markets continues to deepen, some of the outflows will come to Tokyo as well as to the US. Still, it is an odd world when despite everything Japan has done to drive the yen down, (and more debasement is expected from the Bank of Japan in April), the yen continues to serve as a safe haven.

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