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Over the past few days, traders have been buzzing about the sharp declines in the yuan. So far, the currency has dipped to its six-month low against the U.S. dollar and has chalked up its steepest fall since November 2010. What the heck is going on?

It’s no secret that China is showing signs of another economic slowdown lately. For one, its HSBC flash manufacturing PMI has been lingering below the 50.0 mark for a couple of months already, as it dipped to a seven-month low of 48.3 for February. Although analysts attributed this bleak reading to the lower number of working hours during the Chinese New Year holidays, it can’t be denied that the world’s second largest economy is no longer performing as well as it used to.

Another factor that ushered in yuan depreciation is the People’s Bank of China’s preference for a weaker currency. An actual intervention move hasn’t been announced yet, but it’s not unlikely that the Chinese central bank is up to something. According to a report by the Wall Street Journal, many believe that the PBoC is pushing for yuan depreciation order to discourage speculative capital inflows from investors seeking to profit from China’s higher interest rates and expected gains for the currency.

Say what?!

Remember those days when the Chinese government agreed to let the yuan float more freely after being pressured by other major economies? Since then, the Chinese currency has enjoyed stellar rallies against the U.S. dollar as traders took advantage of the positive carry from China’s higher interest rates. Like taking candy from a baby, right? Well, the PBoC wants all the candy back!

For five days in a row, the central bank has been fixing the yuan reference rate lower, which basically suggests that they’re giving the currency room to fall further. “We think the recent weakening of the yuan may signal a change in China’s exchange rate policy,” remarked UBS economist Wang Tao.

Sustained losses for the Chinese yuan could spill over to the currencies of other emerging markets, such as Korea and Taiwan. Take note that China is set to hold its National People’s Congress next month and one of the topics to be discussed is the possibility of widening the yuan’s trading band. With that, several market participants are bracing for an even deeper yuan selloff.

I’m sure you’re wondering whether this would affect the Australian dollar or not, as China is the Land Down Under’s number one trading buddy. Economists have already noted that the falling yuan is weighing on copper and gold prices recently, which spells a grim outlook for the commodity-dependent Australian economy. Earlier this week the Shanghai Metals Market, which is the world’s largest copper market based on volume, saw traders rushing to liquidate their copper holdings because of the weakening yuan. This sparked a chain reaction among copper prices in FTSE, as well as other precious metals.

For now though, it appears that forex traders are trying to take this in stride before piling up their risk-off trades. “So far, the reaction of other global markets has been remarkably relaxed, if not perverse,” noted ANZ. “It is questionable how long this can persist.”

Do you think CNY weakness could lead to a risk-off environment and an AUD selloff? Let us know by voting in our poll below!