U.S. Markets open in 4 hrs 5 mins

How the Yuan Reflects China's Currency Policy

Zacks Research Staff

Although China has transitioned to what is now essentially a market economy, in which market activity is unplanned, it still retains many of the characteristics associated with a command economy, where the government owns and influences factors of production.

This is particularly notable in China’s currency policy, which is solely decided upon by the Communist Party of China (CPC) leadership. The People’s Bank of China (PBOC), the central bank of the nation, works with the government to manage the yuan (¥)—also known as renminbi, and meaning “the people’s currency”—on a daily basis in a process known as fixing.

According to a report by the Congressional Research Service, China first pegged the yuan to the U.S. dollar in 1994, at a rate of 8.28 yuan per dollar. This rate remained until 2005, when pressure from trade partners pushed the government to switch to a managed peg system. Under this system, the yuan was pegged to multiple currencies, including the euro, the British pound, the Japanese yen, and the Russian ruble, among others. However, the amount of weight pegged in each currency is not equal, and the information on specific weighting is not publicly available.

The managed peg system allowed the yuan to appreciate until July 2008, when the government paused its movement due to the Great Recession, which as hurting Chinese exporters. The system resumed two years later, and overall, the yuan gained 43% in inflation-adjusted value between 2005 and 2013.

Controlled Valuation

In August 2015, China created a more transparent exchange policy by announcing it would use a reference rate for the yuan’s valuation, which would be equal to the previous day’s closing value on the foreign exchange market. As a result of this decision, the yuan immediately fell to 6.38 per dollar. The government put a stop on the volatility for a few months by holding that rate, but since then, the yuan’s value has only continued to decrease; as of August 2016, the exchange rate is 6.63 yuan per dollar.

Investors have thought for some time that the yuan is overvalued, so it appears that the current trend in depreciation could be the PBOC’s way to allow the yuan to smoothly fall in line with market expectations.

Generally speaking, China has maintained the value of the yuan through its foreign exchange reserve. This refers to foreign currencies held by the PBOC, and in the case of China, is mostly comprised of U.S. Treasury bills (treasuries). These are notes and bonds that have a comparatively higher liquidity. A growing Chinese economy has resulted in the need for more treasuries since more yuan is then being redeemed by exporters, whose business is typically conducted using foreign currencies.

An eased depreciation involves the same strategy, but is executed in a more controlled manner. This prevents the value of the yuan from flat-out plummeting while still continuing to fall in line.

The yuan will likely continue to depreciate as it aligns with market expectations. Unless China’s central government forcefully puts a stop to the yuan’s current movement again, it’s hard to imagine the currency strengthening significantly in the immediate future. Besides, a transparent exchange rate and loosened fiscal policy should help to address previous foreign gripes with China as well.

If interested in investing in the rapidly evolving Chinese economy, there are a few avenues for investors. The WisdomTree Chinese Yuan Strategy Fund CYB seeks to achieve total returns reflective of both money market rates in China available to foreign investors, and changes in value of the Chinese yuan relative to the U.S. dollar.

Another option is the Market Vectors Chinese Renminbi/USD ETN CNY), the first exchange-traded product to give U.S. investors exposure to the Chinese renminbi. There’s also the CurrencyShares Chinese Renminbi Trust FXCH, which is the only ETF that holds physical Chinese renminbi;it tracks the changes in value of the Chinese renminbi relative to the U.S. dollar.

For a look at more investment opportunities in China, check out this special edition of the Zacks Friday Finish Line, where hosts Ryan McQueeney and Maddy Johnson are joined by Brendan Ahern, the Chief Investment Officer of KraneShares.

Stocks that Aren't in the News…Yet

You are invited to download the full, up-to-the-minute list of 220 Zacks Rank #1 "Strong Buys" free of charge. Many of these companies are almost unheard of by the general public and just starting to get noticed by Wall Street.

They have been pinpointed by the Zacks system that nearly tripled the market from 1988 through 2015, with a stellar average gain of +26% per year. See these high-potential stocks now>>

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
WISDMTR-CH YUAN (CYB): ETF Research Reports
MKT VEC-RENMINB (CNY): ETF Research Reports
CURR-CHIN RENMN (FXCH): ETF Research Reports
To read this article on Zacks.com click here.
Zacks Investment Research