In 2012 U.S.-based multinational corporations had significant currency-related surprises: in the second quarter, they were surprised by negative currency impacts associated with euro volatility; in the third quarter, they were surprised by even larger negative currency impacts, despite relative stability in the euro.
2013 promises more of the same. One of three main sources of volatility we’re going to be watching this year is yuan liberalization. No matter how China handles it, yuan liberalization will, by definition, increase yuan-related volatility. If China can’t get it right, the volatility could be catastrophic. China began the unpegging process in 2010 (after a false start in 2005, which only lasted three years until the People’s Bank of China (PBOC) pegged the yuan to the dollar again in 2008), and since then has only widened the band within which the yuan is allowed to float to +/-1%.
In China to date, progress toward a freely floating yuan could possibly too little too late. China has not followed the model of Chile, the only country to date that has managed to unpeg its currency the right way. The Chilean peso was effectively pegged to the U.S. dollar until 1985, when Chile instituted a managed float (the exchange rate was allowed to float within a pre-determined band, which the central bank gradually widened, to +/-12.5 percent in 1997). In 1999, Chile suspended the crawling band and allowed the peso to float independently.The result of Chile’s slow, methodical unpegging of the peso was relative market stability.
Also critical to Chile’s success was the timing of when they began the unpegging process. When Chile began the unpegging process in 1985, there was still a lot of room in the market for the peso to appreciate. Like a company before an IPO, the central bank had a good story to tell investors about the prospects for the currency, investors believed the story, and the currency rose by market forces. Because China started the unpegging process – announced the IPO, as it were – too late, the PBOC will have to adjust the speed at which it widens the band and gets to a free float. The significant question is whether China began the unpegging process at or near the height of yuan value. If investors don’t believe there is room for appreciation, then increasing yuan liberalization could actually cause the currency to crash.
That is what happened in Argentina. There, when the central bank unpegged the peso from the dollar in early 2002, the value of the peso crashed (it lost half its value in the first four days of official trading since the peg was broken). Demonstrations and rioting followed, as the Argentinean economy fell into chaos.
China might be able to get back on the path that will lead to a liberalized yuan without catastrophic volatility, but at this point it’s questionable. To do it will require a much more aggressive, yet still methodical, widening of the trading band. Whether China is able – or willing – to do that is yet to be seen. Either way, expect a significant increase volatility around the yuan than we have seen in the past.
On January 23rd at 2pm ET FiREapps is hosting a webinar, “Managing Currency Risk in 2013” where you’ll get actionable insights into China’s yuan liberalization and other macroeconomic trends that are driving volatility this year. The webinar will also include a discussion around what leading multinational corporates are doing to prepare for this volatility with timely, accurate and complete visibility into their fast-changing currency risks.
Carmen M. Reinhart and Kenneth S. Rogoff, The Modern History of Exchange Rate Arrangements: A Reinterpretation, Princeton University, 13 Nov 2002.