MNI ANALYSIS: Conditions for Wider DLRCNY Band May Be Nearing

--But China Government Has Taken Go-Slow Approach to FX Reform In Recent Years

By Nerys Avery

     LONDON(MNI) - The yuan has been a relatively quiet fixture in domestic and

global markets over the last few months as the People's Bank of China has choked

off the capital outflows and took advantage of a weaker U.S. dollar to engineer

a mild appreciation.

     But recent talk by officials and state media about a widening of the yuan's

daily trading limit against the dollar has injected some excitement into the

market. It has fuelled speculation that a move could come as soon as this month,

after the Chinese leadership wraps up its annual summer retreat in the seaside

resort of Beidaihe.

     Wang Yu, a deputy director of the PBOC's research bureau, got the ball

rolling in June, saying in a speech that the yuan's daily trading range should

be widened to accelerate the overhaul of the exchange-rate system. His comments

were seen as a rebuttal to doubts about the central bank's commitment to making

the yuan more responsive to market supply and demand after May's announcement of

the addition of a "counter-cyclical factor" to the calculation of the yuan's

daily fixing.

     The Financial News, a newspaper run by the PBOC, followed up in mid-July

with a front-page commentary urging the PBOC to allow more volatility in the

Chinese currency and widen the limit on the yuan's daily trading range,

currently set at 2% either side of the fixing. The increase in the band from

0.5% to 2% in March 2014 successfully curbed arbitrage and squeezed the carry

trade, the newspaper said. It also urged the authorities to reduce their

intervention in the foreign exchange market.

     The China Securities Journal, the main financial newspaper run by the

official Xinhua News Agency, chimed in on August 1 with its own front-page

commentary saying the time was right to allow greater volatility in the

yuan-dollar exchange rate. The central bank had managed to crush expectations

that the yuan was a one-way depreciation bet, stabilize capital outflows and

squash the torrent of yuan sales in the forex market, the newspaper said. It

described the Chinese currency as being in its most balanced period in three

years.

     PBOC POSITIONING

     The growing chatter doesn't necessarily mean a change will happen. While it

could be a way for the leadership to float the idea and gauge the reaction in

the markets before taking the plunge, it could just be the PBOC pushing its own

agenda as part of some internal government and Communist Party wrangle over yuan

reform.

     After all, the government and the Party have been doling out platitudes for

years about improving the yuan's exchange-rate formation mechanism and boosting

the market's role in deciding the currency's value. They have yet to follow up

with concrete action. The last major move in exchange-rate management came

exactly two years ago, in August 2015, when the PBOC roiled global markets with

a de-facto devaluation by changing the way the currency's daily value was fixed

against the dollar. There have also been small incremental steps such as

introducing the Renminbi Index, a basket of currencies of trading partners

against which the yuan is valued on a weekly basis.

     Over the past nine months, we've had the annual Central Economic Work

Conference in December, Premier Li Keqiang's annual work report to parliament in

March, the PBOC's annual Financial Stability Report in July and the National

Financial Work Conference that ended on July 15. All of them reiterated the

commitment to greater exchange-rate reform. But the only material development in

terms of exchange-rate management was an announcement at the end of May of a

change in the way the daily fixing is set. The PBOC said it was adding a

"counter-cyclical adjustment factor" into its fixing model with the aim of

reducing volatility - hardly a step forward in giving markets a bigger role in

deciding the yuan's value.

     The main mantra of the government and the Party for just about everything

these days is the need for stability, even as reforms are carried out. That

makes it difficult for the central bank to manage the yuan. Even though there

are continuous pledges to increase the flexibility of the exchange rate, it has

to be done while simultaneously maintaining stability.

     We've seen over the last few months that even as regulators have launched a

severe crackdown on financial irregularities and pushed financial institutions

and markets to de-leverage, they have pulled back as soon as any volatility has

reared its head. This raises doubts over whether the chatter in the media will

translate into a major policy change. On the other hand, the PBOC may believe

that it has enough control over the domestic markets and has done enough to

squash expectations of yuan depreciation to overcome any volatility that might

arise from a major, if still essentially symbolic, change in its exchange-rate

management regime.

     The PBOC has worked hard this year to stem the surge in capital outflows

and reverse expectations for continued currency depreciation after a

bigger-than-expected drop of 6.5% against the dollar last year, the largest

since the current round of exchange-rate reform started in 2005. The PBOC has

managed to steady the ship through tough supervision of existing capital

controls and some tightening of overseas spending by companies and individuals.

     RE-SETTING YUAN FORECASTS

     The yuan's gain of 3.63% against the dollar this year, while mostly a

function of weakness in the greenback rather than appetite for the redback, has

defied expectations and led many analysts to revise upwards their end-2017

forecasts for the currency. HSBC Holdings, for example, lowered its estimate in

June to 6.90 yuan per dollar from 7.10. And in July, Bank of America Merrill

Lynch revised its forecast to 6.90 from 7.05 on the back of capital

restrictions, dollar weakness and political considerations.

     The yuan strengthened against the dollar last week for the fourth

consecutive week. It climbed this week to the highest level in 10 months and

broke through the key resistance level of 6.7 per dollar. The country's foreign

exchange reserves, which have slumped by almost $1 trillion since their peak in

2014, stood at $3.081 trillion at the end of July, according to official data

released on Monday - a $23.9 billion rise from June and the sixth straight

monthly increase. While the gains have been minimal, and mostly due to valuation

effects and other sleights of hand, they still make the headline number look

good and are slowly pushing the total further above the $3 trillion mark that's

widely seen as the central bank's red line that cannot be crossed.

     Having stabilized expectations about foreign exchange reserves and the

yuan, the Chinese leadership may now see a window of opportunity to announce

another step forward in overhauling the exchange-rate regime, burnishing

President Xi Jinping's reform credentials at home and with the U.S. Offering up

a wider trading band as a sop to Washington could help ward off growing trade

tensions. Although President Trump's accusations of currency manipulation

against Beijing have subsided, relations appear to be deteriorating as the Trump

administration is reportedly preparing more aggressive measures against China,

which could spark a trade war.

     Widening the yuan's trading band would be a high profile move, although it

would be a symbolic concession with little real impact and virtually no downside

for China. The yuan is already allowed to fluctuate by as much as 2% either side

of the daily fixing set by the PBOC, but it has rarely exceeded 0.5% given the

tight control the central bank maintains over the domestic foreign exchange

market. So widening the band to 3% or even 5% to provide more flexibility in

theory would actually make little difference.

     Nevertheless, a widening of the band could send a signal that Beijing is

getting ready to tolerate more volatility in the currency, especially as the

one-way depreciation bets have diminished, capital outflows are under control

and the economic outlook has improved. The real intentions of the Chinese

leadership are hard to fathom at the best of times, and the political jockeying

in the run-up to the 19th Party Congress in the autumn adds to the difficulties

of trying to forecast the future, including when it comes to a widening of the

yuan trading band.

--MNI Beijing Bureau; +44 203-586-2244; email: nerys.avery@marketnews.com

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