This is how China manages the yuan


It is not easy to monitor how the People’s Bank of China operates its “managed float” system for the foreign exchange market: the central bank has various tools, public and hidden. Some are more transparent, such as the daily reference rate; others are murky, such as the ability of Chinese authorities to secretly urge banks not to bet against the yuan in proprietary transactions. As the currency dips towards 7 to the dollar, authorities should review the methods available to stem one-way bets against the yuan.

1. How important is daily fixation?

This is the most obvious tool the PBOC has to influence the currency. It sets a benchmark rate each trading day at 9:15 a.m. Beijing time, around which the yuan is allowed to move 2% in either direction. The rate takes into account factors such as the official close of the day before at 4:30 p.m., the evolution of the yuan against a basket of currencies and variations in other major exchange rates. Therefore, encouraging dips at the official close allows the central bank to set lower fixations without sending a strong policy signal or destabilizing markets. One way to grasp the political signal behind the fixing is to compare it to market expectations. A benchmark rate significantly stronger or weaker than expected is generally seen as a signal from Beijing.

Fixing has undergone reforms over the years, with the aim of making it more transparent and market-oriented. China began allowing the yuan to trade within 0.3% of the peg against the dollar in January 2006, widening it to 0.5% in May the following year, 1% in April 2012 and 2% in March 2014. In August 2015, China devalued the onshore yuan in its most dramatic exchange rate reform in a decade. In order to make the fixing more transparent, the PBOC has laid out the factors that banks should consider when submitting quotes for the rate.

3. How can the PBOC guide the rate of fixation?

In 2017, the PBOC introduced a “countercyclical factor” into the fixing formulas that commercial banks use to calculate and contribute to Beijing’s daily benchmark rate. This decision was taken to avoid a fixation that the central bank considered excessively weak at the time. The component was removed and then reinstalled in 2018, before in October 2020 lenders stopped using the factor. Market speculation of a further reintroduction to support the yuan emerged in 2022 as the gap in fixing rates from forecasts widened to levels that could not be explained by calculations based on a fixing model. regular. At the beginning of September, there had been no official confirmation. Some banks submitting fixing quotes reportedly changed their models to deal with yuan weakness in August, without attributing the change to a recovery in the tool.

4. What else can the central bank do?

One of the latest tools of the PBOC is the so-called foreign currency reserve requirement ratio which sets the amount of foreign currency deposits that banks must hold as reserves. A change allows the central bank to fine-tune foreign exchange liquidity in the banking system; for example, the reduction in the ratio will facilitate the supply of foreign currencies, thus supporting the yuan. The PBOC raised the ratio twice in 2021, including an increase to 7% from 5% in May of that year and another to 9% from 7% in December, before a reduction to 8% in April 2022 Prior to these changes, the ratio had not budged since 2007.

5. What about less formal measures?

Chinese officials are not averse to talking their currency up or down when needed. The standard PBOC line on the currency is that the yuan will be held essentially stable at reasonable equilibrium levels. However, in January 2022, when the yuan was at its strongest since 2018, PBOC Vice Governor Liu Guoqiang said that “market and policy factors will help correct any short-term deviations from relative to its equilibrium level. Additionally, to guide market expectations, the PBOC tends to cite statements from the China Foreign Exchange Committee, an industry organization founded by key onshore market players under the guidance of regulators. Some of the committee’s guidance may be targeted to specific transactions. In November 2021, lenders were urged to review proprietary trading volume to “improve risk management”, a comment that was followed by a significant drop in onshore dollar-yuan spot trading volume. .

6. What to do against speculation?

Raising the cost of betting against the yuan overseas was once a favored tactic when China wanted to rein in declines, like in 2016 and 2018. The key is to mop up cash – Hong Kong is by far the biggest market – therefore traders have to pay higher interest rates to borrow the yuan. This can be achieved by having proxy banks buy the currency or refuse to lend their supply to other banks. The PBOC may also increase the issuance of yuan bonds in Hong Kong. For the onshore market, the PBOC had additional tools to raise the costs of yuan bears. During the Sino-US trade war in 2018, when the yuan fell towards 7 to the dollar, the central bank imposed a 20% risk reserve requirement for futures trading to cool currency purchases on the futures market. The rule lasted for two years until the PBOC scrapped it in 2020 after the yuan rebounded.

7. What about capital controls?

Controlling the flow of funds in and out of the country is one of the most brutal instruments. China moved to limit outflows following the devaluation of the yuan in 2015, imposing restrictions on everything from overseas takeovers by Chinese companies to consumers buying insurance policies in Hong Kong, and there have been few signs of letting up. Conversely, the government has encouraged capital inflows in 2021 by launching new channels with Hong Kong for mainland investors to tap into the offshore bond market and wealth management products. As the U.S. Federal Reserve began to tighten monetary policy in 2022, Chinese state-owned enterprises have been urged to exercise greater caution when considering new spending and investment plans. abroad. The central bank could also change limits on foreign borrowing or lending for financial institutions and businesses; the last such movements were observed in early 2021.

8. What about foreign exchange reserves?

China’s foreign exchange reserves are among the largest in the world at over $3 trillion. Policymakers sold billions of dollars in the aftermath of the 2015 devaluation to prop up the yuan. While this can be a useful indicator, it is also influenced by broad dollar gains, which can cause China’s reported reserves to decline. These declines are not necessarily the result of intervention, but rather because the non-dollar-denominated assets of the Chinese stock will have depreciated against the dollar.

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