Why the PBOC has changed the way it computes the yuan’s daily midpoint

China tweaked its formula for setting the yuan’s daily reference mid price on Monday, a move read by many as a technical adjustment that brings the mid price setting closer to the market, while some suggested it could be a first step made towards a free float of the national currency.

The People’s Bank of China uses the mid price to guide the daily fixing of the yuan’s exchange rate against the US dollar, based on its previous closing price against the US dollar, and the movement of a trade-weighted basket of currencies.

The PBOC allows the exchange rate to rise or fall up to 2 per cent from the official midpoint on a daily basis.

Monday’s adjustment by the operator of the foreign exchange trading platform shortens the reference period for those currencies.

The China Foreign Exchange Trade System (CFETS) is believed to have said on Monday the reference period of yuan trading against basket currencies had been reduced to 15 hours from 24 hours.

The new reference period now is from 4.30pm to 7.30am in Beijing (3.30am to 6.30pm EST).

Reuters quoted official sources on Monday as saying the latest adjustment was meant to “better reflect changes in the forex market, and help curb intraday speculative trading activity”.

But Zhou Hao, senior emerging-markets economist at Commerzbank in Singapore, said the move seems designed to block a technical loophole with the reference mechanism.

“Using the old mechanism, the impact brought about by the US dollar is calculated twice by adding the factor of day time trading of a basket currencies to the yuan’s closing price,” he wrote in a note on Monday.

Tim Cordon, ING’s chief Asia economist, views the move as a technical adjustment to end the double counting of changes in the basket of currencies during the Asian session.

He also raised a possibility that the change in the reference mechanism – which in effect makes the mid price closer to market movements – could be an initiative by the PBOC to realise the elimination of the daily mid-point fixing rate altogether.

“China likes to do things in steps, and shortening the reference period is a reasonable step toward eliminating the mid price. It’s hard to think of an alternative first step,” said Cordon.

“Ending the setting of a daily fixing rate would be consistent with how the authorities described their move towards a more market-based exchange rate to the International Monetary Fund (IMF),” he said.

The central bank, which oversees the CFETS, has been trying to reform the way it manages the yuan by making it more market-driven and transparent.

The People’s Bank of China deputy governor Yi Gang has pledged that China wants to transit towards a so-called “clean float” – a pure exchange rate determined only by supply and demand – of the yuan after the IMF approved the currency as the fifth in the elite special drawing rights basket.

“Our long-term goal is a clean float, which entails little intervention. But under the current managed float mechanism, we have to intervene at times to stabilise the market,” Yi said at the time.

Theoretically, a clean float would ideally involve no government intervention. But only when the capital account is fully convertible and the domestic financial markets are sophisticated enough, can the country move towards a clean float.

In reality, only a few currencies, including the US dollar, euro, pound and yen, are free floating, said Professor Frank M Song at the University of Hong Kong.

The yuan had gained almost 1 per cent against the dollar this year by Wednesday morning.

Recognising that Chinese currency is mainly driven by two factors – the movement of the US dollar and China’s capital outflows – analysts with Macquarie said in a report on Monday that the era of one-way depreciation of yuan had ended.

“The yuan will see two-way volatility in 2017 and end the year without depreciation,” they predict.

Analysts at Nomura said in a research note also publishing on Monday that the PBOC had shifted its bias towards yuan tightening, as high propery prices continue to complicate monetary policy.

“[It] could be viewed as a friendly gesture to the Trump administration and an effort to avoid a potential trade war between China and the US,” Nomura said in the report, noting that the technical adjustment would help curb yuan depreciation expectations.

The need to curb asset bubbles was highlighted as part of PBOC’s policy objectives in the Q4 2016 Monetary Policy Implementation Report issued last Friday.

“Curbing asset bubbles” has been added upon the traditional tasks of monetary policy of the PBOC, according to the Q4 2016 Monetary Policy Implementation Report issued last Friday.

The rise in money market rates, driven by the PBOC’s hike in open market operation rates on January 23, “reflected the shift to a marginal tightening stance to curb the property bubble and reduce financial risks”, the report said.