As China’s central bank pulls back from direct intervention in its currency market, officials are reverting to old tools to manage the yuan.
The People’s Bank of China on Monday said the country’s lenders will need to hold more foreign currencies in reserve, a move that will reduce the supply of the dollar onshore. Officials have pulled on multiple levers to influence the yuan since October, when China cut the cost of shorting the currency to zero and removed a key factor used by banks to calculate the daily reference rate. The government has also relaxed capital curbs to allow more outflows and asked financial institutions to limit their offshore financing.
The PBOC is seeking to curb speculation in the yuan without derailing a plan to liberalize the currency and promote its global usage. The removal of the threat of intervention, however, can fuel one-way bets in the exchange rate. With the yuan near a three-year high against the dollar and the drivers for its recent outperformance remaining in place, the PBOC will be under pressure to take further steps to slow the pace of gains. The currency is also close to the strongest since 2016 versus a basket of trading partners.
“On the one hand, the PBOC wishes to make the yuan exchange rate more market-oriented,” said Larry Hu, head of China economics at Macquarie Group. “But on the other hand, it also doesn’t want to see an aggressive one-way rally.”
Traders on Tuesday became slightly less bullish, with the yuan trading at the largest discount to the daily reference rate in seven weeks and the gap with the offshore rate closing. The currency has still appreciated 12% versus the dollar since a low last year. The offshore yuan was little changed at 6.3822 per dollar at 7:25 a.m. Wednesday in Hong Kong after falling for the previous two days.
Should the central bank want to slow the yuan’s rise again, here are four key tools to watch out for.
Reducing dollar supply
The reserve requirement ratio for foreign-exchange deposits could be increased again. At 7% from June 15, it remains far lower than the 12.5% rate for yuan deposits. That would further tighten dollar liquidity onshore, slowing the pace of foreign-exchange loans and narrowing the yield gap between the greenback and the yuan, said Becky Liu, head of China macro strategy at Standard Chartered Plc.
The central bank could also allow lenders to swap their yuan reserves for foreign currencies, or encourage higher interest rates on foreign-exchange deposits to increase the appeal of holding dollars.
The central bank could put a tax on bullish speculative trades. One way to do this is to make it more expensive to bet on yuan appreciation with derivatives. This would be similar to what happened in October, when the central bank significantly reduced the cost of shorting the yuan.
China has one-sided capital account controls. Outflows are restricted while inflows are encouraged, which has boosted demand for the yuan. In recent months Beijing has taken measures to let more money flow out by giving additional quota for funds to invest in securities overseas, but there’s plenty more authorities could do.
Beijing could allow residents to buy more than the $50,000 annual quota in foreign exchange, according to Citic Securities Co. Hong Kong’s plan to allow mainland investors to trade bonds in the city via a southbound trading channel, which is set to be launched as soon as July, would also encourage outflows.
“Should China need to manage yuan expectations any further, it will probably opt to loosen capital restrictions for outflows,” said Stephen Chiu, a strategist for Bloomberg Intelligence. “Other ways — like a much weaker fixing — are less preferable because this would go against the goal of achieving a more market-driven currency.”
The easiest way for the central bank to influence the currency is through its daily reference rate, known as the fixing, which is set at 9:15 a.m. The yuan is then allowed to move 2% in either direction. This would be considered direct intervention, and it’s the tool the central bank used to devalue the currency in 2015.
The PBOC has been tracking closing moves in the yuan when setting the fixing recently, with the rates largely being in line with average estimates in Bloomberg surveys. That suggests the central bank is either comfortable with the yuan’s strength or has shifted its strategy. Back in January, the PBOC set the fixing 0.15% lower than the average estimate by traders and analysts in a Bloomberg survey. That was the biggest bias on the weak side since Bloomberg started compiling the data in June 2018.
Another way to set weaker fixings is to encourage declines at the official close at 4:30 p.m. That’s because the rate factors into the following day’s fixing formula. While it can be an effective way to influence the yuan without sending a strong signal on policy or destabilizing markets, there’s been little sign of that lately.