Yuan in the crosshairs

The Chinese economy has experienced a bumpy start in 2016. Trading on the country's stock market had been suspended twice to prevent markets from panicking, and the value of the national currency, the yuan (also called renminbi), dropped to a five-year low against the US dollar. Earlier this week, an official measure of activity in the giant factory sector fell to its lowest level since mid-2012, stirring fears that the country's slowing economy was in for a hard landing.

Hoping to calm markets before the beginning of the Lunar New Year holiday season this weekend, the People's Bank of China (PBoC), the country's central bank, supported the yuan, which closed at its highest level in almost a month on Tuesday.

But the question remains where China's economy is heading. And, of more interest to money managers: where is the country's currency heading?

Betting against the yuan

According to the Wall Street Journal, several operators of big US hedge funds have been betting big money on the yuan being in for a sharp drop.

Kyle Bass of Hayman Capital Management, for instance, invested about 85 percent of his portfolio "in trades that are expected to pay off if the yuan and the Hong Kong dollar depreciate over the next three years," according to the paper. Bass expects the yuan to fall by as much as 40 percent during that period.

Legendary investor George Soros, who made a fortune by speculating against the British pound in 1992, has also said he's betting against the yuan and other Asian currencies. For China, "a hard landing is practically unavoidable," Soros said at a World Economic Forum in Davos, Switzerland, two weeks ago.

Of course, Soros and other money managers hope to drum up support for betting against the yuan. The more people place such bets, the bigger the pressure on the currency. In the past half year alone, the country's foreign exchange reserves have shrunk by a record $500 billion (458 billion euros).

A mighty opponent

But the central bank still sits on $3,300 billion. Selling part of these reserves would weaken the greenback and strengthen the yuan. This heap of money makes China's policymakers confident speculators like Soros can be kept at bay. "Declaring war on China's currency? Haha!", ran a headline in the "People's Daily," the official mouthpiece of the Communist party.

"Most market players continue to believe that China will devalue its currency further," Gary Cohn, president and chief operating officer of Goldman Sachs, said in Davos. "But most of us think the devaluation will be very slow and very methodical, over a long period of time. It will not be like the Swiss national bank, which moved the peg over night."

In January 2015, the Swiss lifted the peg that had tied their currency to the euro as market intervention to stabilize the exchange rate had become too expensive for the central bank. As a result, the Swiss franc soared by 30 percent.

In China, the opposite could be the case. The country's economy grew by 6.9 percent last year, the slowest rate in 25 years. Without central bank intervention, the yuan would probably weaken further against the dollar. Some argue a weaker yuan is in China's best interest as it would make exports cheaper, thus stimulating the economy.

Currency wars ahead?

But the People's Bank of China did not only focus on the yuan-greenback exchange rate, said Fang Xinghai, head of the International Economic Department at the Central Leading Group for Financial and Economic Affairs, a high-level group of the Central Committee of the Communist Party in Beijing. "China used to have what we call a crawling peg against the US dollar," he said in Davos. This meant a relatively fixed exchange rate, and occasional adjustments.

"Now the stated goal is to move towards a basket approach," Fang added. "This is not something we're just saying. We are serious, and we do it." A basket approach looks at the exchange rate of not just one, but several currencies and tries to keep a certain balance. In China's case, the basket is dominated by the currencies of its main trading partners: US dollar, Japanese yen, euro and Korean won.

The Chinese currency "has been quite stable against that basket of currencies, and not just now, but for the last few months," Christine Lagarde, managing director of the International Monetary Fund (IMF), said in Davos.

"Given the large amount of reserves and buffers" that China has, Lagarde is optimistic that the various changes the country is facing "are perfectly manageable, if the right policies are taken."

Chinese policymakers did deserve credit for the way they're handling the transition to an economy basede more on domestic consumption, said Ray Dalio, founder and chairman of Bridgewater Associates, a US investment firm with $169 billion under its management. But given the slow world economy, low interest rates and ultra-loose monetary policies of most major central banks, he expects more volatility in currency markets, not less.

"Because you cannot move interest rates much, you move currencies more", he said in Davos. "And that smacks of currency wars, not currency cooperation."