China currency weakness shocks investors

February 26, 2014: 9:58 AM ET
yuan dollar currency
HONG KONG (CNNMoney)

The sun will rise in the East. The New York Yankees will make the playoffs. The yuan will strengthen against the dollar.

For years, investors have viewed the steady appreciation of the Chinese currency as one of the few things in life they could count on. Indeed, it's gained about 10% since the middle of 2010.

But markets have been shocked in recent days by a sudden change in direction -- the yuan has fallen 1% against the dollar over the past six days.

One dollar now buys 6.12 yuan, up from a low of 6.04 in late January.

That may seem like a small move, but it's significant for a currency that is tightly controlled and allowed to trade only within a narrow range.

Analysts see the hand of the People's Bank of China in the reversal -- but it's not clear exactly what the central bank is up to.

The move could be part of an effort to put the squeeze on "hot money" -- a term used to describe cash drawn in from foreign markets where interest rates are low, and invested in Chinese assets in the hope of much higher returns.

"The [central bank] could have felt these inflow pressures were excessive and were based off aggressive appreciation expectations, which it has now managed to curb," HSBC analysts wrote in a research note.

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The authorities may also be laying the groundwork for a more flexible exchange rate in the long term, especially as Beijing pushes ahead with economic reforms aimed at giving markets a greater role in the economy.

The State Administration of Foreign Exchange described the recent volatility as "normal" and said it was the result of market participants adjusting their trading strategies, official media reported.

Two-way movements in the yuan would become the norm, in part due to an enhanced role for the market, China's foreign currency watchdog added.

Signs of economic weakness could be contributing to the currency's decline. Factory activity has stumbled in recent months, setting off alarm bells about the pace of growth. And investors remain worried about the risks building in the country's shadow banking system after a period of rapid credit expansion.

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The yuan's decline, should it persist, will prove a major headache for investors that were betting on the currency's steady rise.

Financial products that depend on the yuan's appreciation -- including some complicated derivatives -- are popular with investors in Asia. The bets had been rock solid, but investors are now likely rushing to sell.

The most likely scenario, however, is that this abrupt shift will soon reverse. And investors should be better prepared next time the currency hits a speed bump.

"We think that this week's heartburn about China's currency management is a sign of things to come," Eurasia Group analysts said.

"As Beijing gives up the reins of its currency and the domestic banking sector, however slowly, by definition its ability to smooth the business cycle with currency interventions and stimulus will diminish."

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