Henan bank crisis threatens to derail China’s efforts to maintain a stable yuan

For China, a stable yuan, particularly in the face of a rising US dollar, is an important symbol of market confidence in its financial system
Now, though, the banking crisis in Henan, where billions in deposits have gone missing, could shake investor faith and drag down the yuan if Beijing does not act swiftly

Neal Kimberley

Published: 12:30pm, 19 Jul 2022

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Working for a stable yuan on currency markets has been a policy cornerstone for the People’s Bank of China (PBOC) of late, the central bank’s success being reflected in the stability of the renminbi against a basket of currencies even as the values of those currencies fluctuate dramatically on foreign exchanges.

The PBOC will need to double down on this policy. A constant yuan remains in China’s best interests but a dark cloud over Henan province needs to be dispersed lest the issue of renminbi stability comes under market scrutiny.

Even darker clouds elsewhere have already turned into a typhoon. In Sri Lanka, with US-dollar commodity prices already on the rise, broader economic mismanagement and poorly thought-out policies combined to trigger a collapse in the value of the Sri Lankan rupee against the dollar this year.

Exacerbating existing imported-commodity-derived inflationary pressures, this collapse has culminated in economic disaster for the Pearl of the Indian Ocean, as well as massive social unrest and the flight and subsequent resignation of president Gotabaya Rajapaksa.

But Sri Lanka is not China. In China, the PBOC has a handle on matters and has shown candour in addressing developments on foreign exchanges.

While acknowledging, on June 2, that US dollar strength in recent months “had gone beyond expectations”, PBOC deputy governor Pan Gongsheng also made the valid point that “the yuan has been relatively stable compared to the level of depreciation of other major currencies against the US dollar. And it has been stable against a basket of currencies.”

The fact that the yuan has depreciated versus the greenback at a slower pace than other major currencies reflects a greater degree of market confidence in the Chinese economy than other non-US major economies, but it is a confidence that needs to be nurtured.

When US dollar financial conditions are tightening markedly yet the world economy still predominantly runs on greenbacks, Hong Kong benefits from the linked exchange rate system which obliges the Monetary Authority to ensure the Hong Kong dollar remains inside a fixed range versus the US dollar.

Consequently, while higher US dollar-denominated commodity prices affect inflation in Hong Kong, the dollar peg mitigates the risk of yet higher imported inflation through the currency channel.

Mainland China has no such currency arrangement but neither does the yuan truly free float against other major currencies. “Yuan exchange rates are basically stable with two-way fluctuations”, the PBOC’s Pan said last month, and Beijing would like to keep it that way.

Pan Gongsheng, deputy governor of the People’s Bank of China, pictured in Beijing on February 19, 2019. Photo: Simon Song

In that sense, there’s some similarity with a golfing analogy currency markets used to apply to the exchange rate policy of Japan’s Ministry of Finance towards the value of the yen against the US dollar – trading was akin to playing a tournament hole.

As long as the dollar-yen rate traded within certain parameters, it was on the fairway and of no concern to Japanese authorities. But if Tokyo felt that currency markets had hooked the rate too far to the left or sliced it to the right, the Ministry of Finance would infer that it had gone out of bounds and “encourage” foreign exchanges to get it back on the green.

It’s certainly the case today that, with regard to the US dollar-yuan exchange rate, currency markets remain attentive to the mood music emanating from Beijing and “adjust their swing” accordingly.

That’s a measure of currency markets’ continuing perception that if the yuan starts to look like it is heading “out of bounds”, Beijing has the means and willingness to guide players back onto the fairway. But perceptions can be jolted.

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The unfolding banking scandal in Henan province has implications not only within China but also from an international perspective. It is scarcely believable that some 40 billion yuan (US$6 billion), which local depositors believed they were placing in banks approved by the regulator, can seemingly disappear.

It just doesn’t look good. Beijing needs to resolve the situation swiftly, in the process minimising the risk that the scandal fuels a wider loss of confidence in China’s financial system at home and abroad.

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If international investors get spooked, money will walk, and that would make the task of keeping the yuan stable considerably harder.

With US interest rates only going up and the US dollar looking set to stay strong, a stable yuan remains in China’s best interests, but Beijing has work to do to ensure that stability continues. Sorting out the Henan banking crisis would be a good start.

Neal Kimberley is a commentator on macroeconomics and financial markets