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Investors shouldn't fret over Chinese yuan volatility

By letting the yuan drop sharply against the U.S. dollar, Chinese authorities deterred excess inflows in recent days and proved the yuan not a constant one-way bet. But that doesn't mean China will stop the yuan from strengthening over an extended horizon. Thus, investors must avoid panicking and keep the currency's positive longer-term outlook in mind.

China knows that over the long term the direction of the yuan's value against the U.S. dollar is one way: up. China has repressed the yuan's rise for two decades, during which it has swelled into the world's second-largest economy and has managed to remain fast-growing, albeit at a more moderate rate. Pent-up demand for Chinese currency is overwhelming.

(Read more: Are we being complacent over the yuan's decline?)

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In the long run this is positive. China's one-child policy has left it with an aging population, and the country's dependency ratio is set to balloon from around 40 percent today to around than 60 percent over the next three decades. But without a social safety net, this could lead to tensions, unless China can continue to raise living standards. A freely traded and appreciating currency is one way to put more wealth in the hands of savers.

But as it allows its currency to trade more freely, China also knows that liberating this pent-up demand too suddenly could cause the yuan to rise at a counterproductive rate. For instance, excessive yuan appreciation could cause Chinese goods to become unnecessarily expensive for overseas buyers.

By allowing the currency to fall in short-term bursts, China is warding off unmanageable speculation as the yuan's U.S. dollar value continues to grow.

(Read more: Yuan to topple dollar as top reserve currency: Survey)

There are two explanations as to why Chinese authorities would choose this moment to weaken their fixings with respect to the yuan. The first is that the government is looking to entice some more short two-way volatility into the market ahead of moves to further liberalize money markets and widen the currency band from 1 percent above or below the daily fixing to 2 percent.

One way of doing this is by making fixings less predictable. If fixing volatility remains low, at the same time as onshore interest rates head higher, the yuan would become a potentially even more attractive destination for carry trades, which could damage the country's competitiveness. This would be particularly problematic if it comes at a time when other regional foreign exchange rates are declining relative to the dollar.

Another way China can steer the yuan is to undertake active and unpredictable intervention. Seven-day repo rates have declined at the same time as the Chinese central bank has been removing liquidity and the currency has been weakening. This suggests that the central bank could indeed be actively intervening in the market today to deter "hot money" flows.

Either way, the government appears to have been successful in injecting short-term uncertainty. Implied volatility has jumped sharply for CNH (off shore) options with six months to expiry or less, even if it has remained relatively stable for long-term options.

The second explanation is that the government is using such methods in response to the sharp downward move in other emerging market rates. It previously set weak fixings in May 2013, the last time we saw a sharp depreciation in other emerging market foreign exchange rates. The yuan's real effective exchange rate appreciated by around 10 percent in 2013 alone.

However, despite these short-term tactics, longer-term yuan appreciation is set to continue. China is still experiencing inflows with respect to foreign direct investment and sports a current surplus worth 2 percent of gross domestic product. Yuan appreciation would be consistent with the country's much-needed rebalancing toward consumption and away from exports and investment, and with its need to put more wealth in the hands of its savers.

(Read more: Is China getting ready to widen the yuan's band?)

And with foreign exchange reserves of $3.8 trillion, the country has ample defenses even if it starts to see capital outflows. Nevertheless, investors should bear in mind that uncertainty over the central bank's fixing policy and over China's economic growth will mean currency volatility is likely to be elevated in the months ahead.

Alexander S. Friedman is the Global Chief Investment Officer of UBS Wealth Management and UBS Wealth Management Americas and is the Chair of the UBS Global Investment Committee. In this capacity, Alex oversees the investment policy and strategy for approximately $1.7 trillion in assets.

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