As China’s central bank props up yuan, the risk of depreciation falls
Hao Zhou says while history and recent moves by the People’s Bank of China indicate that the country will prop up the yuan, the currency is unlikely to appreciate significantly in the near term
No man ever steps in the same river twice, but the People’s Bank of China (PBOC) has. It recently confirmed that the so-called counter-cyclical factor mechanism has been reintroduced to ease the depreciation pressure on the yuan.
This is another move by the Chinese authorities to stabilise the currency, as the yuan has fallen sharply since trade tensions started to escalate. Yuan exchange rates received a big boost on the news.
Indeed, the market had already sensed some behavioural change in the yuan fixing pattern since mid-June, as the PBOC continues to prop up the currency.
That said, the counter-cyclical factor might have been in the system for the past two months. It seems the PBOC’s announcement was simply an “official acknowledgement”, which is more like a warning to China bears.
The counter-cyclical factor was first introduced in May 2017 when the yuan came under great depreciation pressure.
The PBOC stated that the counter-cyclical factor was meant to prevent “herd behaviour” in the foreign exchange market.
The current yuan fixing mechanism, whereby China sets a daily “fix” or reference rate each day and traders and investors are allowed to trade up to 2 per cent on either side, is based on two factors: the closing rate of the yuan on the previous trading day and the movement of a basket of currencies overnight.
According to the PBOC’s explanation, if the dollar appreciates overnight, the yuan reference rate is likely to further weaken the currency as the fixing mechanism aims to maintain the yuan’s stability against the currency basket.
Thus, there seems to be a significant risk of a self-fulfilling spiral forming: the weaker yuan “fix” could fuel greater expectations of yuan deprecation, especially when the dollar is on the rise.
Since May 2017, market makers have been asked to add the counter-cyclical factor, a calculation method that has not been officially explained, into the yuan fixing model to prevent pro-cyclical activities in the foreign exchange market.
To be blunt, the counter-cyclical factor appears to be nothing more than a black box that prevents calculation of how the yuan rate is fixed based on the procedure specified by the PBOC.
Ultimately, the counter-cyclical factor conceals the fact that the central bank sets the course of the currency according to its own agenda.
Obviously, the market will not simply change its expectations based on stronger daily yuan fixes. In the meantime, the PBOC also introduced a slew of measures, largely administrative policies, to ease the depreciation pressure.
With economic indicators improving and the dollar softening, the yuan eventually appreciated in the second half of 2017.
In January 2018, when the yuan strengthened to 6.3 per dollar, the PBOC removed the counter-cyclical factor from the fixing mechanism, signalling that the central bank believed yuan depreciation risks had been reduced.
Yuan exchange rates remained stable in the first half of 2018, but the currency experienced a sharp depreciation after June as trade tensions escalated.
However, recent action by the PBOC, including the resumption of the counter-cyclical factor, suggests that the central bank has stepped up support for its currency again.
If history is a guide, there is seemingly little depreciation risk for the yuan in the foreseeable future.
The more important question is whether the yuan will appreciate significantly from now on. Unfortunately, this does not make sense from both the economic and trade war perspectives.
The weakness of the Chinese currency is justified as the economy is still struggling between growth, debt and leveraging.
Furthermore, as there is no clear solution to the US-China trade war for now, it is certainly not in China’s interest to let its currency appreciate to appease the US.
All told, the re-introduction of the counter-cyclical factor suggests that “bottom-line thinking” remains a key characteristic of China’s policymaking process.
From this perspective, it is not surprising that state-owned financial institutions would provide support to peer-to-peer internet lending platforms that are already in deep trouble. Remember, the government still has a strong direct influence over economic activities and financial markets.
Hao Zhou is senior emerging markets economist at Commerzbank