Future money uncertainties

External factors have caused the recent rise in the yuan's spot exchange rate and the fall in its forward trading rates

The yuan's spot exchange rate against the US dollar has appreciated to a maximum daily ceiling more than 20 times since Oct 8.

The drastic appreciation, which has caused more and more domestic discussions about whether the yuan has entered a new appreciation cycle, is in sharp contrast with its continuous depreciation during most of the first half of this year. With a strong appreciation tendency, the yuan has continuously hit a new high against the dollar since China first launched reform of its exchange rate mechanism in 1994.

Compared with its robust spot exchange rate, the yuan's forward exchange rate, however, has gone the other way. Data from Bloomberg indicate that the one-month forward exchange rate discount for the yuan was 0.98 percent in mid-November, the biggest discount since December 2008. At the same time, its one-year non-deliverable forward contract price has also kept declining. Despite a slowed declining momentum recently, the yuan's non-deliverable forward contract price is still far below its spot exchange rate, and such a tendency is expected to continue.

What factors have been behind the recent drastic rise in the yuan's spot exchange rate and the opposite tendency in its forward exchange rates?

The increasing risk awareness following the launch of the second round of global quantitative easing has served as a direct external factor for the yuan's latest round of appreciation. In the face of a deteriorating sovereign debt crisis in the eurozone since the third quarter of this year and a lingering global economic slowdown, stagnation and even recession, all major countries have shifted the focus of policies and efforts to how to maintain economic growth.

In the context of soaring debt, central banks in major developed countries have begun an unprecedented race to loosen their monetary policies. After two rounds of long-term refinancing operations, the liabilities held by the European Central Bank have reached 3.2 trillion euros ($4.14 trillion), while the debt held by the US Federal Reserve has soared to $2.9 trillion. It is expected that the debts held by the ECB and the Federal Reserve will rocket even higher following the ECB's unlimited outright monetary transactions and the latter's open-ended third round of quantitative easing. Since the launch of a plan for purchasing assets, Japan's central bank has also raised the amount of such purchases nine consecutive times. The unrestrained monetary easing efforts by central banks in the world's developed countries have prompted the inrush of global liquidity to emerging economies as risk hedging.

Compared with developed countries, China's central bank, however, has chosen to inject liquidity into the market through reverse repurchases instead of using interest rate leverage. This has resulted in a much higher benchmark interest rate in China than comparable rates in the United States and offered chances for overseas funds to flow to China for arbitrage from the yuan-dollar interest rate gap. The influx of speculative capital to yuan-denominated assets has thus fueled its continuous appreciation.

The unreasonable distribution of China's overseas assets remains an important structural factor underlying the yuan's latest round of appreciation. Statistics indicate that China's net overseas assets reached $2 trillion, which was the $3.2 trillion reserve assets held by the government sectors minus the $1.2 trillion debt held by its nongovernment sector. The imbalanced assets and liabilities distribution between government and private sectors has left the possibility for drastic yuan exchange rate fluctuations at a time of drastic turbulences in the international financial market.

With a strong yuan against the dollar, most of China's import and export enterprises that previously used dollars for transactions have thus chosen to borrow dollars from banks instead of buying them. Such a practice will not only help them gain benefits from the yuan's higher interest rates but will also help them profit from the yuan's appreciation against the dollar. However, such a practice can also easily accelerate drastic fluctuations in the yuan's exchange rate against the dollar.

Due to increased wishes for exchange rate settlement among Chinese enterprises and residents with foreign transactions following expectations of a weak dollar amid the monetary easing by central banks in developed countries, the yuan has once again embarked on a trajectory of forced appreciation. This proves once again that China's government-tilted holding of overseas assets has amplified the risk of its exchange rate fluctuations.

Taking a longer perspective, the yuan is now within range of an equilibrium exchange rate. Data indicate that the yuan's real effective exchange rate has increased by 21 percent since 2005 when China initiated reform of the yuan's exchange rate regime for the second time. Its real effective exchange rate has also been 1.94 percent higher than its equilibrium exchange rate since 2010 when China relaunched such reforms. In this context, it will be difficult for the yuan to continue to maintain its strong appreciation tendency.

Future uncertainties surrounding the yuan's exchange rate now come from the outside world. If Europe fails to pull out of its lingering debt quagmire and the US falls over its "fiscal cliff", the global economy and financial market will plunge into turbulence. This would cause the dollar to become a risk-hedging choice again for overseas funds, which will unavoidably induce the yuan's depreciation.

The author is an economics researcher with the State Information Center.