It’s been noted by many market participants over the past few months that the gold-Chinese renminbi – aka the yuan, CNY (onshore yuan), and CNH (offshore yuan) – has tightened into virtual lockstep. This post explains this relationship and why it’s happening. The Mythical Reason There’s one narrative saying that the tight gold/CNY correlation stems from the following logic/sequence of events:___ 1. There is a lot of gold-based collateral associated with Chinese lending deals 2. There are underlying problems in the Chinese financial system (overly leveraged) 3. Lenders are becoming anxious over said leveraging issues 4. Therefore they are reclaiming said gold collateral and selling it in the market, leading to record gold shorts and coinciding with the fall in the yuan from early-June to mid-August ___ But this is a fallacious China bear argument and is more conspiratorial than rooted in reality. The More Accurate Reason In markets as large as the yuan and gold, the tight correlation between the two is being led at the sovereign level (China is doing the management through their state banks). It’s not a product of private banks and other institutions mechanically reacting to China’s trade-related FX management against the USD by selling gold in conjunction. Correlations in multi-trillion dollar markets between a currency and a commodity with different fundamental drivers behind them don’t get that sustainably tight like that. China is directly intervening in futures markets to keep the prices and costs of certain commodities stable relative to the yuan. This is being done in order to isolate the yuan’s depreciation relative to the dollar to the greatest extent possible. This means mitigating the economic consequences of US trade tariffs without ideally producing any collateral damage by creating distortions elsewhere.The Mechanics and Difficulties Managed depreciations are a difficult thing for central/state banks to execute. And this is especially true when trying to do it against a currency paying a rate similar to your own. China’s interest rates are fairly similar to US rates, which means the financial penalty to holding USD isn’t that much worse than holding CNY. That means if the market picks up wind of the fact that a certain currency is a one-way bet, controlling the pace and extent of the down move will be tough if your real (inflation-adjusted) rates aren’t relatively high. Namely, investors are more likely to hold onto a your currency knowing they’ll get a return for doing so versus the one you’re managing against. This is a standard carry trade concept. That’s not really the case with holding CNY over USD, because the extra annual return of holding CNY over USD is just 2.35% in nominal terms and 3% in real terms. So what ends up often happening is that banks will end up burning through their FX reserves to control the depreciation. China knows this already because it burned through roughly a trillion dollars of reserves managing its currency down in 2015-16. China of course has the reserves, but when you don’t it can be a disaster – e.g., Britain 1992, Turkey and Argentina and their FX tribulations this year. China also has the controls to make this type of management work. It’s largely sealed off the border by controlling its capital account. Its external asset base is high, which creates demand for the yuan, and the value of these assets are far beyond its external debt, for a net position of some $2.5 trillion held among the PBOC, state banks, and its sovereign wealth fund (CIC). The Appropriate Level of Yuan Depreciation If you take 25% tariffs and assume 25% of China’s global exports are to the US, and the trade elasticity and USD/CNY exchange rate elasticity are both 1, that means that China could manage a 6.25% depreciation (25% * 25%) in the yuan to offset the tariff effects (which has already been done). Trade elasticity is somewhat greater than 1 in reality because China’s productivity in the sectors impacted by trade is increasing, so the appropriate move would be somewhere greater than 6.25%. China of course worked through all this math in a more involved manner than what’s displayed here for brevity. China managed a 7% down move in the currency (vs. USD) from early June to mid-August while keeping the yuan constant relative to certain commodities like gold in order to isolate the effect of the depreciation, and the exchange rate has been stagnant since. Gold has been flat since then as well.