China's market turmoil since the start of the new year has put the spotlight on a not-much-noticed quirk of trading the mainland's currency: the offshore yuan doesn't always want to stay in tune with its onshore peer.
What's the difference between the onshore and the offshore yuan?
While China has slowly been opening its markets, the country still doesn't allow a completely free flow of capital across its borders. The onshore yuan, also called the renminbi, is constrained by a trading band: China's central bank, the People's Bank of China (PBOC), lets the yuan spot rate rise or fall a maximum of 2 percent against the dollar, relative to the official fixing rate, which is set daily.
But the offshore yuan, abbreviated as the CNH, trades freely, based on market forces.
The offshore market was created in 2010 to help "internationalize" the currency for purposes such as hedging and investment, but not trade. Trade settlement can be done through a designated clearing bank in Hong Kong.
Why were China's policymakers so concerned?
In November, the International Monetary Fund (IMF) agreed to add the renminbi to its Special Drawing Rights (SDR), a type of international reserve asset. It will join the euro, yen, pound and dollar in the reserves basket. The yuan will have about an 11 percent weighting in the SDR. The renminbi's addition will take effect in October.
That means the renminbi is now officially recognized as a reserve currency, in a reflection of the changing dynamic of the world's economy.
But one of the requirements of the SDR is that the onshore and offshore yuan need to converge toward a free floating rate. As markets sold off this month, the two currencies diverged.
The dollar was fetching as much as 6.7511 yuan offshore on January 7, compared with 6.5926 yuan onshore, a large spread. At Wednesday's close, the dollar was worth 6.5648 yuan offshore and 6.5743 yuan onshore.