Chinese yuan at the lower limit; will central bank begin the defense of the yuan?

The widespread assumption of a stronger yuan faces a tough test here as the market pushes the yuan right to the lower edge of the trading band. Last week, central bank moves to strengthen the yuan lasted for two days before it resumed its fall. At this point, one side must give: either the yuan rallies or the central bank lowers the daily fixing to stay in line with the market.

I can find articles discussing China's desire to defend the yuan for political reasons (U.S. elections), but found no discussion of what it means if China begins depleting its dollar reserves in order to maintain the value of the yuan. China's large reserves and capital controls will mask the situation, but if the currency becomes overvalued, U.S. dollars will start flowing out of the banking system.

Key to the picture is the euro and yen, but for the moment more so the euro. Since the currency basket is unknown, no one knows the impact of euro weakness, but if it drops sharply versus the U.S. dollar, the yuan should decline as well. Failure to move lower with the euro would indicate the yuan is overvalued, attracting speculators who will start taking U.S. dollars out of the system.

A NYTimes article from Friday provides some explanation for a weaker yuan: Chinese Data Mask Depth of Slowdown, Executives Say
Questions about the quality and accuracy of Chinese economic data are longstanding, but the concerns now being raised are unusual. This year is the first time since 1989 that a sharp economic slowdown has coincided with the once-a-decade changeover in the country’s top leadership.

Officials at all levels of government are under pressure to report good economic results to Beijing as they wait for promotions, demotions and transfers to cascade down from Beijing. So narrower and seemingly more obscure measures of economic activity are being falsified, according to the executives and economists.

“The government officials don’t want to see the negative,” so they tell power managers to report usage declines as zero change, said a chief executive in the power sector.

Another top corporate executive in China with access to electricity grid data from two provinces in east-central China that are centers of heavy industry, Shandong and Jiangsu, said that electricity consumption in both provinces had dropped more than 10 percent in May from a year earlier. Electricity consumption has also fallen in parts of western China. Yet, the economist with ties to the statistical agency said that cities and provinces across the country had reported flat or only slightly rising electricity consumption.

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