Latest Chinese puzzle has markets baffled

Sometimes watching the People's Bank of China building a strategy is like watching somebody trying to solve an ancient Song dynasty Tangram puzzle – a series of flat shapes combined to make a specific shape but one that is hard to judge until the solution appears. Or doesn't.

Market players will be hoping that the PBoC has a solution in mind. It is damnably confusing trying to work out what it is up to with the devaluations of recent days, partially because it seems to be a combination of cutting the value of the currency, then propping it up.

Clearly the notion floated initially that the intervention was a “one-off” is not real as a day after the devaluation was announced the authorities were in the markets again propping up the renminbi in the dying minutes of trade. This was ostensibly about allowing market forces to play more of a role in setting the exchange rate, while stopping it falling too far.

At one stage the yuan was down to its lowest level in four years in mainland trade, around 6.45 yuan, but then the PBoC told state-owned investors to buy dollars on its behalf in the last quarter hour of trade. The upshot of this intervention was that in the final moments of trade the currency jumped about 1 per cent in value against the dollar to 6.3870 yuan.

One analyst at Spreadex described it as “an utterly baffling move one that reflects a worryingly lack of clarity and/or sense in the decision-making process”.

Susan Joho, an economist at Julius Baer, was intrigued by the way the PBoC said in an accompanying statement that from now on it would refer to the previous day's market closing prices in determining future CNY fixes while taking into account demand and supply conditions. "If taken by the word, this would mean that the Chinese yuan would actually become a floating exchange rate."

But the idea of a floating exchange rate must be anathemic to the ruling Communist Party, which, despite professions to the contrary, will not allow the market to have a free run if it in any way threatens stability. If capital outflows start to pick up pace the likelihood is that Beijing will come in again to keep things stable.

It's a delicate balancing act as Beijing wants to be included in the IMF's Special Drawing Rights currency basket. If the perception is out there that China is an active combatant in a currency war, its ambitions for inclusion could be stymied.