China's weakening currency

HONG KONG (MarketWatch) - The recent reversal in China's currency has caught many off guard. While it appears to be a policy-led move to curb an extended yuan carry trade, investors have reason to feel nervous.

As well as fretting about how far the yuan /quotes/zigman/4869230/realtime/sampled USDCNY -0.1176% will be allowed to slide in order to flush out hot-money flows, there is the risk that other asset markets may also change course. Here, the prime candidates are China's bubbly property market and its shadow-banking wealth-management products.

The consensus so far is that the People's Banks of China (PBOC) has things under control and that the 1.3% fall in the yuan over the past two weeks - the biggest correction since 2005 - is designed to introduce two-way volatility as China inches towards a more market-determined exchange rate.

Because China runs a closed capital account with a crawling peg that can only rise or fall by a maximum of 1% a day from a 'midpoint' set by the central bank, the thinking is that authorities can more or less set the value of the currency as they please.

But as this column argued in recent weeks, China now has a strong currency which is creating other problems that are becoming hard to ignore.

Traditionally, investors point to China's ever-growing pile of foreign-exchange reserves as evidence of robust fundamentals which underpin continued yuan strength.

Yet more recently, this fund accumulation is being buoyed by financial arbitrage, as greater returns in the Chinese mainland's onshore market - particularly in the shadow-banking system - attract hot money.

There appear to be a number of factors supporting this fund inflow. One reason the policy-supported yuan has looked particularly attractive is that so many emerging-market currencies have weakened in the wake of the Federal Reserve's taper. Meanwhile, since China loosened controls on its exchange rate in 2010, the currency has risen about 10% against the dollar.

Another explanation is the unintended consequence of China's piecemeal approach to financial liberalization, where yuan internationalization has gone hand-in-hand with domestic deregulation, such as an explosion in loosely regulated wealth-management products. Trying to maintain a sealed capital account when you are now the biggest trading nation on earth always sounded like a tall order.

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Hundreds of Russian troops surround a Ukranian military base in Crimean town of Perevalnoe early Sunday morning. Photo: Getty Images

And while last year we have had controversy when yuan inflows were being disguised in trade figures, attention is more recently focusing on the amount of foreign-currency borrowing by Chinese corporation to fund a yuan carry trade.

Brokerage Jefferies warned recently that Hong Kong's financial system was in the middle of an 'invisible carry trade' as lending to mainland China has surged to almost $400 billion since 2009.

Barclays estimates that, last year, China saw massive capital inflows, meaning the PBOC had to accumulate another $510 billion of foreign reserves, taking its reserve pile to $3.8 trillion. This year, they add, are more signs of surplus inflows, with foreign-currency settlement and sales by banks on behalf of their clients jumping to a one-year high in January of $76.3 billion.

While most analysts welcome the move by the PBOC to deliver some two-way volatility to the exchange rate in order to curb speculative capital, they may have left it rather late. The concern is that the inflows have already added considerably to the fragility of China's economy and its financial system.

For one, the suspicion is that this funding has helped prop up China's most obvious bubble in the property sector. Data this year show that, as industrial-activity readings reverse, one of the few sectors of the economy that's still chalking up big numbers (bar credit creation) is property prices.

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