A History of the British Pound

In today’s article, we will provide a recap of the history of the British Pound. According to the yearly BIS Foreign Exchange Turnover published in April 2016, the British pound is part of the G10 currencies and is the fourth most ‘traded’ currency with a daily average of 649 billion Dollars. Its percentage share of average daily turnover stands at 12.8%, and its two main ‘counterparties’ are the US Dollar ($470bn) and the Euro ($100bn).

Note that the exchange rate $/£ [or USD/GBP] is also called Cable, a term that derives from the advent of the telegraph in the mid-1800s. Transactions between the British pound and the US Dollar were executed via a Transatlantic Cable, and the first exchange rate was published in The Times on August 10th 1866.

This article will be split in two parts; the first one will [briefly] retrace the origin and the history of Sterling until the End of the Bretton Woods system in 1971, and the second part will explain the trends and reversals of Cable in addition to stating what I believe were the main drivers of the currency pair (from 1971 to today).

I. Origin and History of the Sterling pound between the mid-700s and the end of the Bretton Woods system (1971)

A. Quick history recap

Considered to be the oldest living currency in the world, the pound is 1,200 years old and was born in the latter half of the 8th Century, when silver pennies were the main currency in the Anglo-Saxon Kingdoms. The name [Sterling] pound (or Livre sterling in French) comes from the Latin word Libra Pondo, which means pound weight.

Back in the 8th century, 240 silver pennies represented one pound of weight and it was not until 1489 (under Henry VII) that appeared higher denominated coins with the first pound coin. Then, paper notes began to circulate after the establishment of the Bank of England in 1694, the world’s second oldest central bank (after the Sveriges Riksbank, the Swedish central bank). The Bank of England started as a ‘private company’ with the immediate purpose of raising funds for King William III’s war against France (issuing notes in return for deposits).

Even though there is an infinite amount of [inspiring] work on the Bank of England and the British currency, I am going to move directly to the 19th century when the British pound became the world’s reserve currency for a century after the Napoleon’s defeat at Waterloo in June 1815 (Foreign Exchange Reserves, Image 1). Great Britain arose as the leading exporter of manufactured goods and services and the largest importer of food and industrial raw materials. Between the mid-1800s and the outbreak of WWI in 1914, 60 percent of the global trade was invoices and settled in British pound (B. Eichengreen, 2005). London became the world’s financial capital in the late 19th century and the export of capital was a major based for the British economy until 1914. As foreign governments were seeking to borrow in sterling, British financial institutions established branches in the colonies and colonial banks opened offices in London. In 1913, Sterling’s share in the Official Foreign Exchange Assets stood at 48%, above Francs (31%) and Marks (15%) according to Lindert’s calculation (1969).

B. WWI outbreak and its consequence on the UK (and Sterling)

Although the US economy surpassed the British economy in size [in real terms] in 1872 (Gheary-Kamis, 1990), the important switch occurred in the early 1910s:

  • the US became an net creditor while the became a net debtor
  • and more importantly, the Federal Reserve was established in 1913 (December 23rd), with the enactment of the Federal Reserve Act

At the outbreak of WWI, the gold standard was suspended and restrictions were placed on the export of gold, which obviously had a negative impact on the British pound (vis-à-vis the US Dollar) as we can see it on Chart 2a. Prior to and during most of the 19th century, one pound was roughly worth 5 US Dollar (Chart 2b), with some ‘turbulence’ in 1860s due to the American Civil War.

Severe inflation (20%+), lack of demand, a high unemployment rate (above 10%) in addition to a 25-percent drop in economic output between 1918 and 1921 launched the Great Depression in United Kingdom at the end of WWI, which last for two decades. The pound first plummeted from $4.70 to $3.50 during that 3-year period before swinging back to its prewar levels (at $4.87).

C. ‘In between’ the Two Wars

The pound ‘rebound’ in the early 1920s (Chart 2a) could be explained by the political desire to maintain the value of Sterling at a ‘high’ rate (i.e. prewar levels) to give Britain an [economic] successful image to the rest of the World. In order achieve that, the UK had to run contractionary fiscal and monetary policy (Image 2a), which increased interest rate differentials (i.e. attracted savings in Britain) and pushed the UK inflation rate below the US one. As the US inflation rate was already very low at that time, the UK was experiencing deflation at that time (Image 2b).

Then, in 1925, Britain re-adopted a form of Gold Standard where the exchange rate was determined by the relative values of gold in the two countries, with a fixing at 4.86 US Dollar per unit of Pound. This Gold Standard ‘return’ was considered to be disastrous (Churchill’s biggest mistake as he was serving as the Chancellor of the Exchequer at that time), as it resulted in persistent deflation, high unemployment rate that led to the General Miners’ Strike of 1926. The UK was stuck in the debt vicious spiral; running a contractionary fiscal and monetary policy during a deflationary recession was increasing both the amount of UK debt in real terms and its burden (high interest rate increased the cost of borrowing). This led to a Balance of Payments issue, and led to a run on the pound. On the top of that, the Wall Street Crash and the beginning of the Great Depression put the British economy under intense pressure, which eventually came off the Gold Standard in September of 1931. In the year that followed, the British pound dropped to lower lows to around 3.25 against the US Dollar. However, as Barry Eichengreen noted in his paper Fetters of Gold and Paper, countries that came off the Gold Standard early (i.e. UK) did better [or less worse] than the countries that remained on it for longer (i.e. US). After a 3-year [1930-1932] pronounced deflationary period in the US (Image 3), rapidly rising prices in the summer of 1933 (after the US went eventually off the gold standard on June 5th 1933) eased the ‘strain’ on other countries and kicked off the dollar depreciation. The British pound rapidly recovered its losses and surged to a new high of $5 by 1934 (Chart 2a). The pound remained afloat and oscillated at around $5 until 1939 and the outbreak of WWII. This depreciation (which brought back the British pound to its low of 3.25 against the greenback) was mainly due to uncertainty around the outcome of the war, as fundamentals were expected to deteriorate very quickly (output collapse, a rise in inflation) indebting the British economy even more.

D. World War II and Bretton Woods period

In 1940, an agreement between the US and UK pegged the pound to the greenback at a rate of $4.03 per unit of pound. This exchange rate remained fixed during WWII and was maintained at the start of the Bretton Woods system (Chart 2a). British emerged from WWII with an unprecedented debt of nearly 250 percent as a share of GDP (most of it owned to the US) with ‘strong’ currency, a [much] less dominant market in terms of competitiveness and a degrading balance of payments (Hirsch, 1965). Despite the soft-loan agreement (a 3.75 billion-dollar loan to the UK by the US negotiated by JM Keynes at a low 2% interest rate with repayment over fifty years) to support British overseas expenditure post WWII, the British pound remained under intense pressure. Chancellor of the Exchequer Sir Stafford Cripps eventually announced a 30-percent pound devaluation from $4.03 to $2.80 in September 1949.

However, the devaluation was not enough as the following two decades were characterised by persistent balance of payment problems and led to the Sterling crisis of 1964-1967. The UK was forced to seek assistance from the Bank of International Settlement and the IMF more than once. Despite persistent current account deficits and a deteriorating balance of payments in 1964-1965 (Image 4), UK officials didn’t react (i.e. devalue) as they argued that devaluation would severely strain Britain’s relations with other countries when the main holders of sterling would begin to withdraw their balances from London and also threaten the international monetary system (Bordo & al., 2009). The pound weakness persisted in 1966 and 1967, covered by lines of credit received by other central banks (i.e. swaps with the NY Fed) and the IMF. But the government eventually ceded and PM Harold Wilson announced that the pound would be devalued from $2.80 to $2.40 on Saturday 18 November 1967. It then remained at that level until end of Bretton Woods.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon 1971 Shock and Smithsonian Agreements (1971 – 1973)

In addition to signing the Smithsonian agreement at the December 1971 G10 meeting, where the US pledged to peg the dollar at $38 an ounce (instead of $35 during BW) with 2.25% trading bands (instead of 1 percent), the UK also agreed to appreciate their currency against the US Dollar. The pound was worth $2.65 by the end of the first quarter 1972.

B. 1973 – 1976: a rough start

However, it did not take too long for troubles to ‘come back’ in the UK and the pound experienced a series of speculative attacks in the mid-1970s. Cable hit a low of $1.5875 in the last quarter of 1976 and the UK had to call the IMF to counter persistent runs on Sterling. This loan was followed by a series of austerity measures, which helped reduce inflation and improve the economic activity, hence boosting the pound in the second half of the 1970s.

C. 1976 – 1980: US inflation and the Dollar depreciation

The positive UK-US carry trade due to low interest rate run by the Fed in the mid-1970s (as a response to the post first-oil shock recession) gave birth to a four-year shining period for Cable, which recovered by 54% to hit a high of $2.45 in the last quarter of 1980.

D. The V shape of the 1980s

I like to describe the 1980s as a V-shape curve for Cable as there were two major trends during that period. As a result of the second oil shock caused by the Shah revolution in Iran in 1979, oil prices doubled in the following year leading to a sharp increase in inflation in the US in 1979-1980 (peaked at 15% in the first quarter of 1980). In order to reign in the double-digit inflation, Fed chairman Volcker reacted immediately by orchestrating a series of interest rate hikes that levitated the Fed Funds target rate from 10% to nearly 20%. Even though the dramatic increase in interest rates caused a painful recession and a surge in unemployment rate (11%) in the US, it eventually led to international capital inflows as high [real] interest rates became attractive to foreign investment. What followed was a severe appreciation of the US dollar vis-à-vis the major currencies; Cable lost more than half of its value and hit a historical low of $1.0520 in the first quarter of 1985 (Chart 1). This Dollar Rise under the Reagan administration was a problem for the US economy as the current account fell into substantial and persistent deficit (Image 5a). In addition, the US was also running large budget deficit of 5%+ during the same period (Image 5b), which put the country in a twin deficits anomaly and caused considerable difficulties for the American industry (i.e. car producers, engineering and tech companies…).

Therefore, in order to re-boost the US economy, the Plaza Agreement was signed in New York on September 22nd 1985 and France, Japan, West Germany and the United Kingdom agreed to depreciate the US Dollar by intervening in the currency markets. This decision created a secular change in the financial market and immediately reversed the 5-year bull momentum on the US Dollar. The Pound reacted and appreciated roughly 80 percent in the following three years. I am not sure if the [financial] sentence ‘Don’t fight the central banks’ came from this decade, but I think it is a good example to show you how much effect a central bank cohort move can have on the market.

E. 1988 – 1992: the volatile period

We saw a consolidation between 1988 and 1989 to $1.51 after Margaret Thatcher’s Chancellor of the Exchequer Lord Lawson decided to unofficially peg the British pound to the German Mark (UK wasn’t in the Exchange Rate Mechanism yet (Image 8, green period). This caused inflation, a credit bubble and a property boom that eventually crashed in 1989-1990 followed by a recession.

Cable started to recover in the first quarter of 1990 as the interest rate differential increased preference for the British pound (Chart 3). In the middle of 1989, the Federal Reserve began to run a loose monetary policy in order to boost the US economy weakened by the Savings and Loan crisis of the 1980s and 1990s. Fed’s chair Alan Greenspan decreased the Fed Funds rate from 9.75% in March 1989 to 3% in September 1992 to boost productivity (Chart 3). Cable double topped at [perfect] resistance $2.00, a first time in Q1 1991 and a second time in Q3 1992.

It is also important to note that during that time, the Conservative government (Third Thatcher ministry) decided to join the Exchange Rate Mechanism on October 8th 1990 (Image 8, grey period), with the pound set at DM2.95.

16 September 1992: Black Wednesday and ERM exit (Source: Inside the House of Money)

Also called [another] Sterling crisis, the British government was forced to withdraw the Pound Sterling from the ERM on that day, sending the pound into a free fall. Cable tumbled by 30% from [Q3 92] peak to [Q1 93] trough. But what really happened then?

As we mentioned before, the UK tardily joined the ERM in 1990 at a central parity rate of DM2.95 and a trading range band of +/- 6 percent. The exchange rate was arguable judge too strong by many economists at that time, therefore the overvalued currency in addition to high interest rates and falling house prices led the country into a recession in 1991. It became difficult for UK officials to maintain the value of the Pound at around its target against the Deutsch Mark. Meanwhile, Germany was suffering inflationary effects from the 1989-1990 Unification, which led to high interest rates. Therefore, despite a recession, the UK was ‘forced’ to keep interest rates high (10% in September) to maintain the currency regime. Speculation began and global macro traders (i.e. Soros) increasingly sold pounds against the Deutsche Mark. To discourage speculation, UK Chancellor Lamont increased rates to 12% on September 16th with a promise to raise them again to 15%. However, traders continued to sell British pounds, as they knew that increasing rates to defend a currency during a recession is an unsustainable policy.

Eventually, on 16 September 1992, the UK government announced that it would no longer defend the trading band and withdrew the pound of the ERM system. The pound lost 15 percent of its value against the DM in the following weeks and traded as low as DM2.16 in 1995.

Even though we usually do our analysis of a specific currency vis-à-vis the US Dollar, I thought it was important to mention the presence of the Deutsch Mark as it explained Cable’s depreciation in 1992 and 1993.

F. 1993 – 1998: the Dull period with shy Sterling Gains

After the ERM exit, it was dull period for the USD/GBP, Cable oscillated around $1.60 with a shy little upward trend (i.e. shy GBP gains) helped by the small interest rate differentials and a series of trade balance surpluses. It looks like the $1.70 psychological resistance was hard to break between 1996 and 1998 and the Pound traded within a ‘tight’ 10-figure range during these years.

One important event during that period was that the Monetary Policy Committee was given operational responsibility for setting interest rates in 1997 with one [only] mandate: maintain a 2-percent inflation rate in the long run. Traditionally, the Treasury set interest rates.

G. 1999 – 2002: The Sterling Depreciation

 As we saw for the Euro (and the Yen at a lesser extent), the turn of the century was marked by a Dollar appreciation between 1999 and 2002. Cable lost a bit of steam during that period and spent a lot of time flirting with the $1.40 support in 2000 and 2001 (it even hit a low of $1.37 in Q2 2001). I have not found any supportive literature to explain this downward bias, but it is not absurd to assume that some of the dollar strength came from a surge in the equity market capitalization in the US – with the Tech Boom – and potentially a higher productivity than in the United Kingdom.

H. The 2002 – 2008 GBP appreciation (or US Dollar depreciation)

The US Dollar started to tumble in late 2001 / early 2002, which was the beginning of a 6-year bull period for Cable. The exchange rate went north 50% and reached a high of $2.11 in the last quarter of 2007 (with a small consolidation in 2005). The (inflation-adjusted) trade-weighted dollar exchange rate (i.e. see REER) steadily depreciated, falling by roughly 25 percent (Image 6). During that period, US was printing persistent twin deficits: Current Account deficits print a high of 6 percent in 2006 (Image 7a) while Budget deficits were ranging between 2 and 3.5 percent as a share of GDP (Image 7b). In addition, the Fed decreased interest rates to 1.75% after the 9/11 attacks and then to 1 percent in 2003, helping the government to roll its debt at lower costs and finance the Iraq War (total cost to the United States was at 3 trillion USD according to Stiglitz and Bilmes, 2010).

I. 2008: Financial Crisis and the Risk-Off aversion

The British pound saw a massive depreciation in 2008 due to the risk-off sentiment and the sudden demand for Dollars; Cable tumbled 36%+ from [Q4 2007] peak of $2.11 to [Q1 2009] trough of $1.35. In the early 21th century, Sterling had lost its reserve currency for a long time, so when asset prices took a massive hit in 2007-2008 the pound did too. The two currencies that acted as ‘strong’ safe-havens were the US Dollar and the Japanese Yen. This raised an interesting debate on whether countries should have huge amount of debt (denominated in their local currency) in order to have a currency that acts as a safe-haven in harsh period. When you think about it, the two safe-havens are the currencies of the two most indebted nations ($20tr for the US and $11tr for Japan, as of today).

The UK was sharply impacted by the crisis; to give you an idea, the pound’s [36-percent] fall vis-à-vis the US Dollar wasn’t even enough to make up for weakening foreign demand. It took the country’s economy 6 years to come back to its pre-crisis level (summer 2014, ONS), with a debt-to-GDP ratio that soared from 51% in 2008 to 89% in 2014.

Bank of England’s answer: Like many other central banks, the BoE slashed rates from 5 percent in the beginning of 2008 to 0.5% in Q1 2009 (the lowest since the BoE establishment in 1694). In addition, the Bank of England press the QE bottom like in the US and created £375bn of new money between 2009 and 2012.

The series of measures adopted by central bankers brought back interest in the Sterling pound, considered to be ‘cheap’ or undervalued relative to its peers. Cable regained 50% of its value in three quarters and hit a high of $1.71 during the third quarter of 2009; however, the recovery wasn’t very long as the Sovereign debt crisis emerged in Europe (at that time is was Greece) and impacted the British economy (and its currency) as well.

J. 2011 – summer 2013: the other dull period

Bizarrely, the British pound wasn’t affected too much during the [second] EZ sovereign debt crisis between Q3 2011 and mid-2012. For almost two-and-a-half years, Cable traded around $1.50-$1.60 with pressure on the downside in the beginning of 2013. The pressure came after it lost its top AAA credit rating for the first time since 1978 on expectations that growth would ‘remain sluggish over the next few years’. At that time, traders were starting to predict that Cable would retest its 1.40-1.4250 support range as the Pound was clearly not a hot currency in the beginning of 2013. In addition, investors were also starting to look at the Euro’s momentum after the buy-on-dips that followed Draghi’s ‘Whatever it takes’ in July 2012.

Despite the UK weakness, the British pound didn’t fall to further levels as it was ‘saved’ by a dovish Fed and a US Dollar in the coma. In the last quarter of 2012, Bernanke announced a further round of QE with monthly purchases totalling $85bn (of Treasuries and MBS) in order to boost productivity. This prevented the British pound of depreciating too much and raise interest in the cheap Euro at that time.

K. August 2013: New BoE Governor Mark Carney took office and the Pound experienced a fantastic year

In the summer of 2013, Marc Carney left the Bank of Canada to take over Mervyn King’s place as the new Governor of the Bank of England. Then, what followed was a series of good news and positive fundamentals in the UK; the British pound switched from the no-interest status to traders’ favourite currency (with the Euro, there were the market’s Darlings). Cable soared from its $1.48 lows to hit a 6-year high of $1.72 with market participants pricing in a sooner interest rate hike. Cable’s good driver of that one-year bull period was the increase in implied rates [looking at the short-sterling futures contract]. Moreover, Britain was the fastest-growing major economy in 2014, printing an annual growth of 2.9% (surpassing the US and its 2.4%).

L. Summer 2014: the Dollar wake-up and the start of a Bear currency market for the Pound

As I already wrote it in a previous post on the UK, the last positive words on the British economy came out of Carney’s mouth during a speech he gave at the Mansion House on June 12th 2014 (the same night of the kick-start of the World Cup in Brazil). He said that the UK was on a positive momentum (i.e. fundamentals were good) and hinted that the Bank of England may rise rates sooner than the market expected. At that time, I remember that the futures market was pricing in a 25bps hike by the end of Q4 2014.

However, everything vanished a few weeks later and more and more participants were starting to notice that the British pound was showing signs of ‘fatigue’ and that a consolidation was coming. In addition, May 2014 was also the announcement of the ‘Euro’s Death’ and that the single currency expected depreciation may spur an overall Dollar strength. And it happened… According to the DXY index, the Dollar strengthen by 25 percent against its main trading partners between July 2014 and March 2015. Cable tumbled from a $1.72 to $1.4635 during that same period.

In early 2015, most of the market participants was pricing in another 15 to 20 percent increase in the Dollar on expectations of the Fed starting a tightening cycle (taking the two previous Dollar Rally that we described earlier as empirical data: the Reagan Rally in the beginning of the 1980s and the Clinton Rally that occurred in the late 1990s).

2016: The Brexit effect and monetary policy divergence

After a brief pause in 2015 as the Fed halted its tightening cycle [due to the sharp sell-off that occurred in the beginning of 2016], Cable continued its bear market against the US Dollar in 2016 on speculation of a Brexit Yes vote first (in favour of leaving the EU), and then on the concretisation of the Yes vote (52% in favour of Brexit) following the referendum held on June 23rd. The pound traded below the 1.20 level against the greenback after the announcement, its lowest level in 21 years, and remains currently under pressure as Brexit uncertainty will continue until Article 50 gets triggered.

BoE answers to Brexit

After four years of status quo [and hints of potential rate hikes], the Bank of England announced a new round of QE in August last year targeting £60bn of monthly purchases (of which £10bn of corporate debt) and cut its Official Bank rate by 25bps to 0.25%. With the Fed now [seriously] reconsidering starting a tightening cycle after a first hike last month and three potential rate increase in 2017 (DotPlot Gradual Path), the monetary policy divergence between the US and UK and the political uncertainty in Europe (and UK) will weigh on the pound in the near future.

Chart 1. GBPUSD historical monthly candlesticks since 1971 (Source: Bloomberg)

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Chart 2a. Cable historical rate 1915 – 2013 

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Chart 2b. Cable historical rate since 1791

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Chart 3. UK Official Bank Rate (Red Line) versus US Fed Funds Rate (White Line)

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Image 1. Reserve currency status (Source: JP Morgan)

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Image 2a. UK Budget deficit in the 1920s (Source: ONS)

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Image 2b. UK Inflation Rate in the 1920s (Source: ONS)

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Image 2c. UK Unemployment Rate in the 1920s (Source: ONS)

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Image 3. US Annual Inflation in 1930-1939 (Source: BLS)

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Image 4. UK Current Account in the 1960s (Source: Trading Economics)

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Image 5a. US Current Account in the 1980s (Source: Trading Economics)

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Image 5b. US Budget Deficits in the 1980s (Source: Trading Economics)

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Image 6. US Dollar REER (Source: OECD)

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Image 7a. US Current Account in the 2000s (Source: Trading Economics)

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Image 7b. US Budget Deficits in the 2000s (Source: Trading Economics)

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Quick review of the Chinese Yuan history

Back in November 2014, I wrote a quick summary of my favorite currency: the Japanese Yen. It was a very useful exercise for me first of all, and I hope it provided interesting information for my readers.

I think this time an interesting story of a particular currency that I tend to watch every morning is the Chinese Yuan or ‘Renminbi’. The difference between the two names: the Yuan is the name of a unit of the renminbi currency (i.e. you can say that a slice of pizza cost 10 Yuan, but not 10 renminbi.

The ‘Dark’ Beginnings… 

The Renminbi, which literately means ‘people’s money’, is the official currency of the People’s Republic of China (PRC). It was first issued on December 1st, 1948 by the PBoC, Public’s Bank of China, the country’s central bank. The bank was established on the same date under the Chinese Communist Party ruled by the Chairman Mao Zedong (also known as the founding father of the PRC). China experienced a massive monetary inflation between 1937 and 1945 (end of WWII) in order to fund the war with Japan. Studies showed that between 70 and 80 percent of the annual expenditures were covered by fresh printed money during that period. Therefore, the country suffered from a Great Inflation in the same years that was reflected on the exchange rate. Here are some figures (coming from the work of Richard M. Ebeling, the Great Chinese Inflation, 2010):

  • In June 1937, one US dollar was traded at 3.41 against the Yuan
  • By December 1961, the exchange rate of USDCNY rose to 18.93 in the black market
  • At the end of WWII, the Yuan depreciated dramatically to 1,222 (vs. the greenback)
  • In May 1949, USDCNY reached a dramatic 23,280,000

In the 1950s, the Chinese economy was so cut off from the rest of the world that it is difficult to find data on a potential meaningful exchange rate. All the information I have so far is that a second issuance of Renminbi took place in 1955 and replaced the first one at a rate of one new CNY to 10,000 old CNY.

The World Bank published an annual average middle exchange rate for US Dollar to Chinese Yuan since 1960. Between 1960 and 1971, one US dollar was worth 2.4618 Chinese Yuan, which makes me believe that China was ‘also part of’ the Bretton Woods agreements (I am speculating on that information based on the ‘pegged’ exchange rate). Then, after the Nixon ‘shock’, the exchange rate started to depreciate and reached a low of 1.8578 in 1977 before starting to soar to 2.40 in 1980.

The 1980s reform and RMB Devaluation:

With China’s economic reform in the 1980s, the Yuan started to become a more easily traded currency (exchange rate was therefore more realistic), thus data became public. The following historical exchange rates are based on Bloomberg (ticker: CNY BGN Curncy).

Starting with a grossly overvalued exchange rate in 1980, the Chinese Yuan experience a series of devaluation until the late 1990s until the Chinese authority settled the rate 8.27 CNY/USD.

As you can see it on chart 1, the rise of the US Dollar under the Reagan Administration (as a consequence of the Fed rising interest rate to 20% to counter inflation coming from the second oil shock) pushed the USDCNY exchange rate  from 1.65 to roughly 3.00 in September 1985 (before the Plaza Accord on September 22nd). In contrast, the real exchange rate was more much stable and remained virtually constant between 1981 and 1985 (during this period, the Renminbi was pegged to a back a basket of internationally traded currencies weighted according to their importance of China’s trade).

Between 1987 and the end of 1990, the Chinese Yuan was relatively pegged to the US Dollar, with a 26% Yuan devaluation that took place in the last quarter of 1989. However, these devaluations were not sufficient with the emergence of a black market pricing a much higher USDCNY exchange rate (i.e. cheaper Yuan currency against the US Dollar). Therefore, the ‘unofficial’ floating rate (a swap market rate) has constantly driven the ‘official’ rate (nominal rate on chart 1) until the massive devaluation of 1994 (and the official and ‘unofficial’ rates were eventually unified).

1995: The start of a new regime

One the two rates were unified, the Chinese currency was pegged to the US Dollar from 1995 to 2005 at an exchange rate of 8.28 Yuan per US Dollar. Therefore, the PBoC was ready to intervene (i.e. buy or sell Yuan) in the market to keep that rate steady. This policy was combined with a policy of restricting international capital flows, where the citizens were not allowed to convert savings into US dollars, Japanese Yen or British pound.

In consequence, the low exchange rate lead to political issues between US and China as many studies concluded that the Chinese Yuan was an undervalued currency. Exports were growing dramatically in China (see appendix 1), from 160 million US dollars in 1995 to 600 million dollars in 2005 according to the General Administration of Customs. The economic modernization, cheap labour costs in addition to a more ‘transparent’ exchange rate led to a surge in Foreign Direct Investment during the 1990s and 2000s. The economy average an average annual growth rate of 9-10% between 1995 and 2005 (appendix 2).

China’s economic growth and trade liberalization led to a sharp expansion in US/China commercial ties, and a constantly increasing US trade deficit with China. If we look at table 1, the US trade balance deficit widened from USD 10.4bn to USD 201.6bn in 2005, damaging the US economy. There are many reasons why China could have resisted from international pressures to maintain it peg during that period, but the two main ones that come to my mind is that China was mostly financing the US deficit (i.e. purchasing US Treasuries) and the US manufacturing was benefiting from cheap labour costs for goods produced in China.

The 2005 peg removal

Eventually, the PBoC removed the peg on July 21st 2005 and allowed a first one time appreciation of 2.1%, pushing the dollar down to 8.11 CNY. From there, China allowed its currency to float within a range determined in a relation to a basket of currencies (authorities told the world that it ran a ‘managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies’). The basked was dominated by its main trading partners – US Dollar, Euro, Japanese Yen and South Korean Won – with a smaller proportion of other currencies (GBP, AUD, RUB, CAD, THB and SGD). Until Q3 2008, USDCNY fell roughly 18% before the reintroduction of a de facto peg during the financial crisis from 2008 to mid-2010 at around 6.80 Yuan per dollar.

June 2010: A return to the daily trading band limit:

In June 2010, after a two-year peg, China allowed once again USDCNY to trade within a 0.5% band (daily limit for appreciation or depreciation of the CNY against the USD) amidst major pressure from international trade partners. The Yuan’s trading band was then widened to 1 percent in April 2012, which led to further appreciation of CNY (USDCNY fell another 11.60% to reach a low of 6.01 in January 2014).

The Yuan crisis in Q1 2014

In the start of 2014, we saw a little Yuan crisis with USDCNY erasing most of its Jun-2012 / Jan-2014 fall (62% roughly if we look at chart 2). There are many stories that could describe this sudden CNY collapse:

  • the PBoC willingness to join the global currency war and enhance export
  • the carry trade unwinds from structured products build on the hypothesis that the Yuan will appreciate continuously (FX Target Redemption Forward story for instance)
  • other thought that the PBoC was paving ‘the way for further liberalization of the Yuan exchange rate’

I think the carry trade unwinds is the most appropriate based on the one-way market positioning concerning the Yuan before that crisis. Products were structured by banks on the hypothesis that the Chinese Yuan will constantly rise against the USD until it eventually reached its ‘fair value’ which was estimated between 5 and 5.5 at that time (BEER, FEER fair value models). We know that carry trade currencies tend to depreciate gradually during some period so that carry traders could benefit from the interest rate differentials, however the risk-off aversion (i.e. carry unwind) is sudden and very drastic.

In mid-March 2014, the PBoC widened the range to 2 percent (allowing the exchange rate to rise or fall 2 percent from a daily midpoint rate that the central bank sets each morning). Until the August 11 devaluation that occurred the following year, the Chinese Yuan oscillated at around 6.20 against the Dollar.

August Devaluation

On August 11th, the PBoC suddenly allowed the Yuan to depreciate by nearly 2% against the USD, its largest devaluation in the past two decades amid slower economic growth and a depressed highly-volatile stock market. As you can see it on Chart 3, the Shanghai Shenzhen Index (CSI 300) started to enter into a bear market in June 2015 after it reached a high of 5,380. In the beginning of August 2015, the market was almost down 2,000 pts. and the fear of a ‘Chinese bubble collapse’ raised concerns over global investors. A second PBoC move was done the consecutive day and pushed the total devaluation to nearly 4 percent (from 6.21 to 6.44 USDCNY, see chart 4).

Watch the CNY – CNH spread

As China has been opening up its economy to the RoW (Rest of the World) since the late 2000s, the officials’ goal was to internationalize its currency to the market to settle trade and financial transactions. As you know, the CNY – or on-shore Yuan – is not allowed outside of China and is only convertible in the current account (i.e. trade) and not in the capital account (i.e. for investments and banking flows). Thus was born the CNH in 2009 – offshore Renminbi – which circulates in offshore markets such as Hong Kong (China Mainland Hub). Since then, there has been a rapid expansion of offshore clearing centres in financial cities like London or Frankfurt and the RMB has begun direct currency trading against the Euro, GBP, NZD in addition to USD, JPY or AUD.

The important criteria of the CNH is that it is allowed to float freely with no restrictions on cross border trade settlements, therefore I usually like to watch the CNY – CNH spread just to see the divergence sometimes that happens in the market (See chart 5). In the beginning of the year 2016, we saw a massive divergence between USDCNY and USDCNH, with the offshore Yuan (CNH) was depreciating at a much faster pace than the on-shore Yuan (CNY). On January 6th, the spread reached 14 figures, with USDCNY trading at 6.55 and USDCNH at 6.69. Eventually, the situation stabilized and the two exchange rates converged.

I think that by looking at the spread between the two rates, you can gauge the market’s perception toward the currency and its confidence in the PBoC’s policies.

Will the Yuan continue to weaken in the near term?

It has been a few years now that a group of investors have been watching closely China, especially its highly-leverage banking system. Over the past decade, China has expanded its credit market from 5tr USD to 35 trillion USD; for an economy of roughly 10tr USD, the banks’ total-assets-to-GDP ratio stands at 350%. China is massively exposed to the housing market, which represents roughly 15 percent of the country’s GDP (it was 5% in the US before GFC). Therefore, if the housing market halts or starts to decline (which it has already according to some housing market index), the country could be exposed to a non-performing loans cycle and therefore would be forced to recap its banking system, pushing the PBoC to increase its balance sheet. As China doesn’t offer short positions in equities (not very common from my knowledge) and no structured products or derivatives to short the housing market, people are positioned in the currency, expecting a ten to twenty percent depreciation. This scenario could bring the currency USDCNH somewhere between 7 and 8.

Chart 1. Historical USDCNY exchange rates (Source: Bloomberg)

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Chart 2. The 2014 USDCNY ‘crisis’ (Source: Bloomberg)

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Chart 3. CSI 300 Index (Source: Bloomberg)

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Chart 4. China CNY devaluation – August 11th

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Chart 5. CNY – CNH spread (Source: Bloomberg)

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Appendix 1. Exports (Source: Trading Economics)

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Appendix 2. Growth (Source: Trading Economics)

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Table 1. US trade with China (US ITCD)

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