CNH Is the Tail That Wags the Dog

From 2014: The Informational Power of the Offshore Yuan Exchange Rate
When CNH is weaker, Chinese exporters do not bring their dollars onshore. Exporters hoard dollars and wait to buy yuan at the cheaper CNH rate. The arbitrage can close rapidly because they're free to exchange at any time. Foreigners looking to buy offshore need to pay a premium to entice sellers during a yuan rally. This is caused by capital controls, but is also a feature of a multi-year bull market.

When the market is operating under normal conditions, everything seems to indicate yuan strength and China has tight controls on inflows to slow yuan appreciation. But if the market is not normal— if there are no bidders for yuan, but instead a growing demand to hold dollars both onshore and offshore— the offshore yuan is free to tumble. And if CNH tumbles and the financial system sees a dollar shortage, the PBOC has to follow CNH lower to bid the dollars back or it has to spend its dollars (or let them be spent by banks and citizens) to halt the decline in CNH.
China has capital controls, but it can't stop dollars outside of China from staying outside China, nor can it allow USDCNH to float away. CNH is the more legitimate price because it is the market price.

A speculative attack on the yuan seems unlikely because of Chinese reserves, but a speculative attack doesn't have to drain Chinese reserves from $3 trillion to zero, it only has to strike a blow mid-trend. The market has taken USDCNY past 6.70 solely due to U.S. dollar appreciation. The market thinks capital controls will work because they are working, but depreciation expectations in China are only showing up now. Maybe nothing comes of them. Maybe the dollar has peaked. Maybe not.

Risk is much greater than perceived because too many participants have been lulled by the perception of central planning success. Central banks, politicians and central planners do not control the market. They can abuse it and bend it depending on their power, but they cannot destroy market forces. China can limit exports of dollars. If CNH is 6.80 and CNY is 6.75, and you are in China with yuan, but can't buy dollars at 6.75. Dollars can't flow out. Yuan can flow out though, and yuan can be sold overseas. If yuan can't be sold overseas, it can be sold for gold and real estate in China.

Government policy levers work in normal times because most economic activity takes place through limited channels. Market sentiment and psychology are healthy. The trend is often the policymakers friend. When the market and sentiment turn, the policymakers can do nothing right because they were never really in charge in the first place. They are a major player in the market, but also a player. Unless you are the market, you are subject to market forces. If you are the only seller, you can set the global price if there are buyers. If you are the only seller and there are no buyers, the price falls until there is a bid.

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