Why the PBOC is Cornered

There's a temptation to believe China is operating with a well-designed plan but we look at how the latest series of moves have been reactionary. Markets wilted in confusion on Tuesday. The next big test is today's yuan reference rate setting. The latest in the Premium trades, USDJPY hit its final 125.25 target from the 123.90 entry, while EURAUD extended into the green at 1.5120 from the 1.4690 entry. AUDCAD has slipped back into the red.

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The problem with a 'one-time' devaluation is that markets need to believe you. The PBOC doesn't have that kind of credibility. So when they announced the move, market participants instantly came to believe that more devaluation was coming. Almost instantly, the capital outflows began. By extension, that will devalue the yuan further.

The rate-setting mechanism for the yuan is still somewhat market based. It was set at 6.2298 to the US dollar Tuesday and allowed to trade in a 2% band. Throughout the course of the day, it fell another 1.5% to 6.325 and remains under pressure. That means there is a good chance the PBOC will 'devalue' by another 1.5% today.That will underscore the devaluation theme and exacerbate outflows further, causing a viscous cycle and undermine PBOC credibility. The daily announcement is usually at 1:15 GMT (21:15 ET) and expect more of what we saw today if/when it takes place.

Alone, that might have been seen as a cunning strategy from Chinese officials. But the Australian Financial Review also reports that in June the PBOC was very explicit in telling fund managers it wouldn't devalue. That, in addition to the haphazard incursions into the stock market over the past 6 weeks reek of desperation.

Warren Buffett's most-famous saying is that we find out who is swimming naked when the tide goes out. 20 years of blockbuster growth have made every official in China appear oracle-like but endless rising growth has begun to flounder and Chinese officials appear to be splashing around madly trying to stay afloat.