The post Asian Financial Crisis of the 90's marked a change in central bank behavior. There were large build-up in foreign reserves by central banks in order to have a war chest available to defend their currency against an extreme fall. Dollar held as reserves could be sold to buy back local currencies to stop a large uncontrolled devaluation. The objective would be to use reserves to protect against a sudden stop as money flows out of the country. There is a desire to stop any feedback loop that will lead to currency overshooting. The foreign reserves of the PBOC are being put to the test this summer.
Though there has been a 2% devaluation of the yuan, there could be easily a further fall if the PBOC would allow a free float. The tight link with the dollar has pushed the yuan to levels that can be sustain at current growth rates. The outflow of capital even with capital controls is placing pressure on the yuan and the central bank.
It was announced that foreign reserves fell by 93.9 billion in August. The overall foreign reserves at the PBOC has fallen from $4 trillion to about $3.56 trillion since a year ago. If there is a Fed lift-off, this outflow could continue as money flows to the US dollar. Similarly, volatile financial markets are causing Chinese investors to move more capital offshore to safer assets.
The devaluation is not something that the PBOC may want especially if it cannot be controlled. As with the stock market, foreign exchange rates are "too important to be left to the markets". The impact has been a decline in Treasury holdings by the PBOC but these holdings are likely on the front-end of the curve and will not have an appreciable affect on Treasury prices.
Expect further reserve decline and downward pressure on the yuan. This is likely to occur even if there is a Fed decline in raising rates. The most important impact is that more Chinese money will be flowing into US financial markets just when local investors seem more skittish.
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