MNI INTERVIEW: Ex-China SAFE Off'l Sees Yuan Float In 3 Years

--Guan Says No Clear Yuan Appreciation Trend Yet

--China Likely to Relax Capital Controls As Outflows Ease

     BEIJING (MNI) - It is difficult to say whether the appreciation of the yuan

exchange rate this year can continue, but it has provided the People's Bank of

China with the opportunity to relax its strict controls on capital outflows and

push forward its goal of a market-determined "clean float" of the currency, Guan

Tao, former head of the balance of payments division at the State Administration

of Foreign Exchange (SAFE), the government foreign-exchange regulator, told

Market News International in an exclusive interview.

     Guan, now a research fellow with the China Finance 40Forum, an influential

Chinese economic think tank composed of 40 of the country's top economists,

including former officials of and advisors to the central bank, said that a

clean float will be achieved within three years, and possibly sooner. 

     Guan, an expert in exchange-rate mechanisms, said that domestic and foreign

uncertainties cloud the prospects for a stronger yuan. "It is too early to say

the Chinese economy has rebounded to a turning point, and the government also

does not expect the economy can break out of its L-shaped momentum in the short

term," Guan said, referring to a slow economic recovery after reaching a trough.

     "Policy and market sentiment [on the yuan] will be influenced by the

volatility of economic fundamentals. Plus, the U.S. dollar has almost bottomed

out," he said. 

     As of Friday, the yuan had risen 5.83% against the greenback this year,

compared with a net 7.02% depreciation last year, while the U.S. dollar index

has dropped 10.27% after a 3.73% rise in 2016. 

     "I have not seen obvious appreciation expectations so far this year"

despite the yuan's recent rise, Guan said. "For the forward rate, the yuan is

still depreciating against the U.S dollar due to the interest rate spread

between the two currencies" Guan continued, arguing that the yuan's recent rise

"is just a shift of expectations from the previous extremely bearish yuan

[outlook] to the current optimism about the yuan's appreciation." 

     The interest rate spread between U.S. and Chinese 10-year treasury notes

had expanded to 140 basis points as of Sept. 14, more than double the 66 basis

points at the beginning of this year, approaching the highest spread in two

years. 

     But it was certain that the pace of yuan's recent surge, which started Aug.

28 and came to an end Sept. 8 when the central bank began setting the daily yuan

fixing rate at weaker levels, was unsustainable. In those two weeks, the yuan

soared 3.04% from the closing rate of 6.6645 on Aug. 25 to 6.4617 on Sept. 8.

     "When the exchange rate sees sharp one-way volatility in the short term and

continuously breaks key support levels, it is definitely overshooting, which

means a correction will happen shortly," Guan said. "So the strategy of piling

into the yuan and selling off U.S dollars is unwise and risky at that moment." 

     Given the interest rate gap, there is no fundamental factor supporting a

stronger yuan, Guan said. 

     "In the current situation, it is not necessary for the PBOC to follow the

Federal Reserve in hiking rates. [The PBOC] is keeping interest rates from going

up further, so its present policy will not boost the yuan," Guan argued. 

     After the U.S. Federal Reserve last raised the federal funds rate by a

quarter point to 1.0%-1.25% in June, the PBOC has maintained its seven-day

repurchase interest rate for interbank depository institutions at 2.45%.

     SAFE TO EASE CONTROLS ON CAPITAL OUTFLOWS

     With yuan depreciation expectations having withered away, Guan expects

SAFE, a unit of the People's Bank of China, to ease the strict controls imposed

earlier this year to stem increasing capital outflows.

     "The extreme capital controls have succeeded in stabilizing the yuan

exchange rate and maintaining the level of foreign-exchange reserves after the

bad situation at the end of last year," he said, "but the complicated

administrative methods were not in line with the long-discussed goals of

macro-prudential management, so the regulators will adjust the temporary

measures adopted during the extreme [outflow] situation."  

     The PBOC's changing stance was confirmed last week after the central bank

officially announced it was reducing from 20% to zero the reserve requirement

for financial institutions settling their clients' foreign-exchange forward yuan

positions. The PBOC stressed in an email to MNI that it was making the move

because "The yuan exchange rate is moving toward equilibrium, market

expectations are becoming rational, and cross-border capital flows and

foreign-exchange supply and demand have become more balanced." 

     The risk provision on currency forward contracts was originally put in

place in October 2015 as the government sought to restrict dollar purchases at a

time when the yuan was weakening.

     But Guan said a reduction in the reserve requirement did not mean the rule

was being totally eliminated. 

     "The reduction does not mean cancellation of the rule," he said. "The risk

provision on currency forward contracts is like a Tobin Tax -- the proposed tax

on international financial transactions -- especially speculative

currency-exchange transactions. It has become a normal tool for the PBOC to

manage the market. If market sentiment were to worsen, it would re-impose the

tax." 

     Other restrictions, including controls on overseas direct investments, are

likely to be relaxed gradually. Guan noted that each month since March, banks'

sale of foreign exchange to clients has seen positive year-on-year growth after

decreasing for 13 consecutive months -- a sign that easing has been occurring

for the last six months.

     Other restrictions will be eased soon. "Legal and appropriate overseas

direct investment, which was curbed in the past year, will be released," he

said.

     It is as yet unclear if the slight capital inflow seen in the past few

months will continue. "The capital and financial account [including errors and

omissions] still showed a deficit of around $42.2 billion in the first half of

the year, and the large yuan appreciation occurred only recently, plus economic

fundamentals have been giving mixed signals," Guan said. 

     CONFIDENT OF CLEAN YUAN FLOAT IN NEAR FUTURE

     Guan said he is confident that a clean float of the yuan exchange rate can

be achieved and thinks the current daily central parity mechanism is just a

temporary step in the process of reaching a market-determined float.

     "The market sees the daily fixing largely as a signal of PBOC policy,

particularly after the introduction of the 'counter-cyclical [adjustment]

factor,'" Guan said. "The PBOC also uses it as a way to communicate with the

market," Guan said.

     In its latest tinkering with the fixing formula in May, the PBOC added the

counter-cyclical adjustment factor. The yuan's appreciation accelerated from

that point.  

     During the period from Aug. 28 to Sept. 11, the fixing rose for 11

consecutive sessions by a total of 2.04% against the greenback, which was

interpreted by traders as the PBOC supporting the yuan's appreciation.

     Guan said the PBOC will have to optimize the fixing mechanism. "It is not

in line with the goal of the exchange-rate reform, because in an exchange-rate

regime where the market plays a decisive role, it is impossible to set a

quotation based on one formula. Only when market participants have their own

pricing models will the market have enough liquidity. Otherwise, there will only

be one-way transactions," he said.

     It is possible to achieve a clean float in three years, Guan argued. "Based

on the blueprint on comprehensive reform set by the government in late 2013,

it's supposed to make decisive achievements in market-oriented reforms by the

end of 2020," Guan said. 

     "The need to guarantee the independence of currency policy will be greater

than the need to maintain the exchange rate at a certain level, because the

Chinese economy is getting bigger and the economic system more complicated. So

the cost of maintaining a managed float would be huge and the [positive] effects

of administrative controls will be limited," Guan said.

     To reach the target, the PBOC will have to increase the flexibility of the

yuan exchange rate. Reforms will not be successful if policies swing between

controlling inflows and controlling outflows, which would hurt the credibility

of the country, Guan said.

     But Guan also said that the PBOC has not finished "optimizing" the pricing

mechanism for the daily yuan fixing, and that more factors may be added to the

calculation based on market changes and emerging events. 

     "A lesson from the yuan's internationalization process is that [government]

policies can shift, particularly if authorities want to achieve several goals

with a single policy, but this can make the targets unclear and lead to negative

effects on market expectations," he said.

     "China should learn from the U.S. 'strong dollar' policy stance, which does

not mean the yuan must appreciate. The currency exchange rate should be based on

economic fundamentals -- a strong economy supports a strong currency," Guan

said.

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

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

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

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