(Bloomberg) – As China’s central bank pulls out of direct intervention in its currency market, officials are reverting to old tools for managing the yuan.
The People’s Bank of China said on Monday that the country’s lenders will need to hold more foreign currency in reserve, a move that will reduce the supply of dollars on land. Officials have pulled multiple levers to influence the yuan since October, when China reduced the cost of shorting the currency to zero and removed a key factor used by banks to calculate the daily benchmark rate. The government has also eased capital restrictions to allow more outflows and asked financial institutions to limit their offshore funding.
The PBOC seeks to curb yuan speculation without derailing a plan to liberalize the currency and promote its global use. Removing the threat of intervention, however, can fuel one-way bets on the exchange rate. With the yuan at a three-year high against the dollar and the drivers of its recent outperformance remaining in place, the PBOC will be under pressure to take further action to slow the pace of gains. The currency is also close to the strongest since 2016 against a basket of trading partners.
“On the one hand, the PBOC wants the yuan exchange rate to be more market oriented,” said Larry Hu, head of the Chinese economy at Macquarie Group. “But on the other hand, he doesn’t want to see an aggressive one-sided rally either.”
Traders turned a little less bullish on Tuesday, with the yuan trading at the steepest discount to the daily benchmark rate in seven weeks and the spread to the offshore rate closing. The currency has appreciated another 12% against the dollar from a low last year.
If the central bank wants to slow the yuan’s rise again, here are four key tools to watch out for.
Reduction in dollar supply
The reserve requirement ratio for foreign currency deposits could be further increased. At 7% as of June 15, it remains well below the 12.5% rate for yuan deposits. This would further tighten the liquidity of the landed dollar, slow the pace of foreign currency lending and reduce the yield spread between the greenback and the yuan, said Becky Liu, head of macro strategy for China at Standard Chartered Plc.
The central bank could also allow lenders to exchange their yuan reserves for foreign currencies, or encourage higher interest rates on foreign currency deposits to increase the attractiveness of holding dollars.
The central bank could impose a tax on bullish speculative transactions. One way to do this is to make it more expensive to bet on the appreciation of the yuan 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 unilateral control of the capital account. Exits are limited while entries are encouraged, which has boosted demand for the yuan. In recent months, Beijing has taken steps to let more money out by granting additional quotas for funds to invest in overseas securities, but authorities could do much more.
Beijing could allow residents to buy more than the annual quota of $ 50,000 in foreign currency, according to Citic Securities Co. Hong Kong’s plan to allow mainland investors to trade bonds in the city through a trading channel to the south, which should be launched as soon as July, would also favor exits.
“If China needed to manage yuan expectations further, it would likely choose to ease capital restrictions on exits,” said Stephen Chiu, strategist for Bloomberg Intelligence. “Other means – like a much lower fixation – are less preferable because it would defeat the goal of getting a more market-oriented currency.”
The easiest way for the central bank to influence the currency is to use its daily benchmark rate, known as the fixation, 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 this is the tool the central bank used to devalue the currency in 2015.
The PBOC has been tracking the yuan’s closing moves when fixing the fixing recently, with rates largely in line with average Bloomberg survey estimates. This suggests that the central bank is either comfortable with the strength of the yuan or has changed its strategy. In January, the PBOC set the fixation 0.15% below the average estimate of traders and analysts in a Bloomberg survey. It 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 PM. This is because the rate is taken into account in the next day’s fixing formula. While this can be an effective way to influence the yuan without sending a strong signal on politics or destabilizing the markets, there has been little sign of it lately.
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