MNI China Analysis: Yuan Exchange Rate Volatility Tests PBOC

--Yuan Unlikely to See Another Big Surge Like That In Late Aug-Early Sep

--PBOC May Be Willing to Tolerate Larger Yuan Swings; Some See Band Widening

--New Study by Ex-PBOC Officials Sees Groundwork for Eventual Yuan Float

     BEIJING (MNI) - The seemingly flexible stance and tolerance of the People's

Bank of China regarding the yuan exchange rate has been challenged over the past

month as the yuan has fluctuated in a wider trading band, forcing the central

bank to re-evaluate how far from shore it will allow the yuan to float before

throwing in a lifesaver.  

     The yuan exchange rate has largely followed a "V" shape against the U.S

dollar since Aug. 25, with a rapid strengthening followed by an equally rapid

weakening. 

     The yuan witnessed a sharp rise from Aug. 25 to Sept. 8, with the closing

price surging 2,028 pips from 6.6645 to 6.4617 over the 11 trading days. The

daily trading rate jumped as high as 6.4350 during the period, the strongest

level since May 2016.

     The sharp appreciation was attributed to a softer U.S dollar, which

resulted in a surge of U.S. dollar sales in the domestic forex market,

particularly by institutional participants who had previously been bearish on

the yuan. However, the PBOC's tacit permission for the yuan to strengthen

undoubtedly boosted the positive market sentiment and accelerated the process.

Notably, the PBOC appeared to have become more neutral on the yuan exchange

rate, as least before Sep. 8. According to Commerzbank, the spread between the

actual fixing rates of the yuan and the Commerzbank fixing model moved less than

60 pips in 20 days from the middle of August, compared with over 100 pips in the

20 days in the middle of May when the "counter-cyclical factor" was introduced,

implying that the PBOC barely intervened in the market. 

     The PBOC'S daily yuan fixing strengthened significantly by 1,582 pips from

Aug. 25 to Sept. 11 as the U.S dollar continued to unwind, with the central

parity of 6.4997 on Sept. 11 the strongest since last May.

     However, Sept. 11 was also the day the PBOC put the brakes on the yuan when

it announced it would lower the reserve requirements for FX forward purchases

from 20% to zero. In addition, the central bank also removed the reserve

requirement imposed on offshore yuan deposits placed with onshore agent banks.

     The moves sent the market a signal that the yuan's sharp appreciation had

moved beyond the PBOC's comfort zone.

     "I think the 6.4 level [to the U.S. dollar] will be the bottom line of the

PBOC for yuan appreciation this year," a Shanghai-based FX trader with a

joint-stock bank told MNI. "[The PBOC'S] purpose was to maintain stability, and

the sharp rise was obviously not in line with that purpose, particularly before

the 19th National Congress of the [Communist] Party," which starts Oct. 18.

     Meanwhile, the PBOC's daily yuan fixings provided more clues to the central

bank's changed stance. On Sept. 12, the fixing was set at 6.5277, 280 pips

weaker than the previous day -- the biggest daily decline since Jan. 9 this

year. The fixing continued its depreciation path after that. As of Friday, the

fixing had weakened 1,372 pips since Sept. 11, including five consecutive days

of weaker fixings this week.

     Since the PBOC added the "counter-cyclical factor" into its fixing

calculation model in May, analysts believe it began a new method for intervening

in the FX market -- through the setting of the daily yuan fixing, and not solely

by buying or selling foreign-exchange reserves in the market. So far, the effort

has had a positive effect, considering that the depreciation expectations seen

prior to May have largely dissipated.

     Li Liuyang, an FX analyst with China Merchants Bank, told MNI on Wednesday:

"We expected the fixing today would be a bit lower than the closing rate on

Tuesday since the U.S dollar index hit 93 after [U.S. Fed Chair Janet] Yellen's

speech last night, but the fixing proved to be much lower than the closing rate,

which would be a signal of stability maintenance." 

     "As the yuan exchange rate is approaching the level it was at on Aug. 25,

when the currency started to rise, the PBOC is expected to take more action," Li

said.

     The yuan has been weakening on a daily basis since Sept. 11, falling 2,082

pips as of Thursday's closing time and breaking the 6.70 level the same day,

wiping out all its gains during its rapid appreciation in late August and early

September. 

     A Beijing trader with one of the big five state-owned banks told MNI that

the latest depreciation was "partly due to the increase of FX purchases,

particularly after the PBOC cut the reserve requirements for purchases of

foreign exchange forwards."

     "At present, market expectations are diverging at a fast pace, and we can

see that daily trading volume is decelerating as the prospects [for the yuan]

are unclear," he said. Still, FX purchases have remained relatively strong ahead

of China's week-long National Day holiday next week, in part because Chinese

tourists were buying foreign currencies as they headed off on overseas tours. 

     Ding Meng, a London-based China economist with Bank of China, told MNI:

"The rebound of the U.S dollar is the main cause of the current depreciation of

the yuan.  The previous surge was mainly driven by speculative forces, not yuan

purchases by bank clients who held large amounts of dollars, so speculators

began to withdraw [from the yuan market] as the appreciation began to reverse."

     Because it is easy for the market to turn "irrational," as the PBOC has

stated, the central bank stands ready with its "necessary guidance" for the

forex market. In fact, the PBOC has kept its steadying influence on the market

since early this year, when the yuan was widely expected to break through the

7.0 level against the greenback. The yuan softened to as weak as 6.9666 against

the greenback on the last trading day of 2016, and stayed at weak levels into

the new year.

     The latest yuan depreciation seems to have stirred up the market's

irrational nature once again. On Thursday, the yuan closed at 6.6699, 349 pips

weaker than Wednesday's close, breaking the 6.67 level in daily trade, much

weaker than the fixing, which was set at 6.6285, the fourth consecutive day the

fixing was set weaker. The spread between the fixing and closing prices of the

yuan expanded to over 400 pips -- the largest spread during a deprecation phase

since January.

     "The fixing today was stronger than our expectation, but the market doesn't

seem to buy it," the Shanghai trader said Thursday. "I am not sure if this

situation will continue, but if it does, the PBOC ... will not sit by."

     The unprecedented volatility of the yuan in the past month -- from a big

surge to a sharp slump -- could indicate that the PBOC has an increased

tolerance for a wider trading band of the currency. More important, the central

bank seems to have unveiled to the market its new dynamic policy-making process

for yuan exchange rate -- in other words, the PBOC is no longer afraid to let

the yuan float on its own, at least for short periods.

     Last weekend, Huang Yiping, a member of the PBOC's Monetary Policy

Committee, admitted in a report that the PBOC had long faced a dilemma in its

exchange-rate policy, with the central bank having had "enough of the fixed-rate

regime" while still being afraid of floating the yuan.  

     The PBOC is "aiming to realize a market-oriented float, but the flexibility

of the exchange rate is far from adequate," Huang argued.

     The report, co-authored by several big names associated with the central

bank, including Xu Zhong, the head of the PBOC Research Bureau, Guan Tao, former

head of the balance of payments division at the State Administration of Foreign

Exchange, and Zhu Min, former deputy governor of the PBOC, argued that now is

the time to increase the flexibility of the exchange rate, as depreciation

expectations surrounding the yuan had basically been eliminated while the

economy had stabilized. 

     "If the yuan exchange rate could complete the 'breathtaking leap' of

market-oriented reform, it would send a very positive signal to the

international community and make China's voice louder in international financial

affairs," the report stressed.

     But taking the that last big step toward a free float still seems

difficult, meaning the PBOC's best choice at the moment is to widen the daily

trading band, although that strategy would have more symbolism than actual

merit. Currently, the PBOC allows the yuan to trade within a range of 2% above

or below the daily fixing, although the actual daily fluctuation has never

reached that limit on either side of the band.

     "Currently, expansion of the trading band seems like it would have the

smallest shock on the market, while sending a signal of a further relaxing of

control," said Ding, the Bank of China economist. He said he believes the PBOC

trading band could be widened to 3% by next year. 

     "As to improving the transparency of the fixing formation system or

allowing a bigger spread between the offshore yuan and the daily fixing [of the

onshore yuan], we could expect that too," Ding said. However, the PBOC is not

yet ready to give up its management of the exchange-rate regime in favor of

letting market forces determine the yuan's value, he added. 

--MNI Beijing Bureau; +86 (10) 8532 5998; email: marissa.wang@marketnews.com

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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