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What's China going to do with its yuan problem?

What's China going to do about its yuan problem? The issue has become urgent after China's foreign exchange reserves dropped by a record $US94 billion ($135.7 billion) last month as the People's Bank of China intervened heavily in foreign currency markets in order to prop up the yuan.

Although China still holds a massive $US3.6 trillion in foreign exchange reserves, there are growing questions as to how long Beijing's enthusiasm for the costly support of its currency will continue.

After all, the intervention in foreign exchange has clearly failed to discourage huge capital outflows from China. As a result, Beijing was last week forced to announce measures to stem capital outflows, including a crackdown on illegal money-transfer agents who help wealthy Chinese transfer funds out of the country.

Capital outflows have been picking up this year because of worries over the country's slowing economy and its share market collapse. But the pressure has intensified in the past few weeks after Beijing's surprise move last month to devalue the yuan and the decision by the central bank to cut interest rates for the fifth time since November.

The problem is that China's sombre economic outlook, combined with the likelihood of further interest rate cuts, is only encouraging wealthy Chinese to send more of their savings offshore, which is exacerbating the downward pressure on the currency.

As a result, Beijing is left with two choices. The first is to stop supporting the currency, and allow the yuan to drop by about 10 to 15 per cent.

A large currency devaluation would discourage wealthy Chinese from trying to move their money out of the country, and may even encourage some investors to buy Chinese assets.

But there are also problems. In the first place, it would fan fears that China is now a major combatant in the global currency wars and is prepared to use a lower yuan to make Chinese exports more competitive in global markets.

This is something that China has consistently denied. At the G20 meeting last weekend, Beijing was at pains to brush aside concerns that it would allow its currency to fall further in order to give its exporters a competitive advantage.

Instead, central bank governor Zhou Xiaochuan told G20 finance ministers and central bank chiefs in Ankara at the weekend that at present the exchange rate of the yuan against the US dollar "tends to be stable".

In addition, a sharp drop in the Chinese currency would also create major problems for those Chinese companies, including many state-owned enterprises, that have loaded up on US dollar loans, without hedging their foreign currency risks.

So this leaves the second alternative, which is for Beijing to gradually scale back its support for the yuan, which would allow the currency to decline more gradually.

However, the prospect of a long and prolonged fall in the yuan is only likely to encourage capital flight out of China, forcing Beijing to counter with an even tougher crackdown on authorised funds transfers.

But, in the short-term, wealthy Chinese wanting to move money out of China know that they have a short window of opportunity to do so.

That's because Beijing is likely to keep propping up its currency ahead of Chinese President Xi Jinping's first state visit to the United States later this month.

China will definitely want to avoid inflaming long-running US criticism that it is manipulating its currency in order to get an unfair economic advantage ahead of this important visit, particularly as outrage over China's alleged foul play has been one of the few issues that both Democrats and Republicans have been able to agree so far on in the 2016 election cycle.

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