China’s central bank has its eye on the bigger picture as it allows market forces to dictate speed of yuan declines

Most analysts believe the yuan could weaken further without causing market panic

PUBLISHED : Monday, 02 July, 2018, 6:30am
UPDATED : Monday, 02 July, 2018, 6:30am

There are signs China’s central bank is letting market forces dictate the speed of recent declines in the yuan amid the ongoing US-Sino trade tensions, indicating that the exchange rate policy may be gradually shifting towards a “cleaner” style floating regime, analysts say.

Between late-2015 and mid-2017, the People’s Bank of China (PBOC) deployed draconian measures to limit sharp, one-way depreciation pressure on the yuan that was triggered from its August 2015 attempt to reform the exchange rate. It imposed capital controls, squeezed market interest rates and added a opaque “counter-cyclical factor” to the formula of the daily yuan reference rate.

But analysts believe that in the current bout of sharp declines in the value of the yuan, policymakers have refrained from intervening in the currency markets and imposing restrictions, underscoring a determination to push through new policies this time round to open up their markets and encourage foreign participation in its domestic equity and bond markets.

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In May, Guan Tao, a former official at the State Administration of Foreign Exchange, said it was possible to have a timetable and road map for the currency to move towards a clean and volatile exchange rate. Before moving to a clean and volatile exchange rate in 2020, policymakers could initially move towards a managed yuan float that would entail no prior announcement of a so-called “floating trading band” and where the midpoint of the exchange rate was truly determined by market forces.

The yuan is transitioning into a Chinese version of a ‘clean floating’ foreign exchange regime with greater two-way flexibility
Paul Mackel, head of global emerging markets FX research, HSBC

The PBOC recently removed the 20 per cent repatriation limit for Qualified Foreign Institutional Investor (QFII) and the three-month lock-up period for QFII and Renminbi Qualified Foreign Institutional Investor schemes. Early this year, it also reduced the influence of the “counter-cyclical factor” to determine the yuan midpoint.

“The yuan is transitioning into a Chinese version of a ‘clean floating’ foreign exchange regime with greater two-way flexibility,” said Paul Mackel, head of global emerging markets FX research at HSBC. “Capital account flows will become a more important driver of the Chinese currency.”

The yuan lost 3.28 per cent of its value to 6.62 against the dollar in June, marking the biggest monthly decline since 1998.

Some policymakers are worried that the opening up its capital account for foreign investment may mean investors can take money out more quickly and lead to a volatile yuan if the currency was more market driven.

The National Institution for Finance & Development, a government-backed think tank, also recently warned of a potential “financial panic” because of risks from bond defaults, liquidity shortages and the recent plunge in financial markets.

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ICBC analyst Cheng Shi, however, pointed out that China was now much stronger, economically resilient than in 2015 and 2016, and that the recent drop in the yuan exchange rate was only a reflection of the dollar index movement.

The absence of market panic or rampant capital outflows so far comes as China’s foreign exchange reserves staying above US$3.1 trillion this year, other analysts noted.

There has been a sell-off in stocks and currencies but no market panic. This means the PBOC is likely to refrain from intervening in the market and let the yuan continue its decline
Iris Pang, Greater China economist, ING Bank

Potential inflows from more A-share inclusion into MSCI’s indices, foreign purchases of China depository receipts and domestic bonds are also expected to offset outflows.

In the past week or so, the PBOC has chosen to use the daily yuan reference rate, a softer tool to slow the drop in the currency by setting a stronger than expected midpoint level, where traders are allowed to only trade 2 per cent on either side of it.

“There has been a sell-off in stocks and currencies but no market panic. This means the PBOC is likely to refrain from intervening in the market and let the yuan continue its decline,” said Iris Pang, Greater China economist at ING Bank.

With US President Donald Trump’s rhetoric over anti-China policies probably escalating going into the midterm elections in November, the PBOC is likely to tolerate a much weaker yuan to help Chinese exports and boost the economy, analysts said.

The outlook for the US economy is still robust because of a solid job market and rising inflation expectations while China’s growth outlook is pointing towards further downside.

ICBC’s Shi predicted that yuan’s two-way volatility band will probably widen to a range of between 6.2 and 6.7 per dollar this year.

ING Bank’s Pang believes the PBOC will tolerate an even weaker yuan, cutting her year-end yuan forecast from 6.60 previously to 7.0 against the US dollar, lower than the 6.9649 hit in 2015 – which also saw the stock market crisis.

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Media have reported that National Development & Reform Commission, the nation’s top economic planner, was considering a ban on offshore bond issuances with a tenor shorter than 365 days.

If the decision goes ahead, that may be a signal that the government was pre-emptively reducing corporate repayment risks as the yuan weakens against the dollar in the coming year, Pang said.