MNI: PBOC Faces Tough Task To Defend Yuan, Advisors Say

The People’s Bank of China faces a tough job to defend the yuan at 7.30 to the dollar as the Chinese economy remains sluggish and the Federal Reserve keeps monetary policy tight, policy advisors and FX traders told MNI, though they added that despite possible further short-term weakness the currency could still strengthen towards the end of the year.

The PBOC has likely restarted its so-called “counter-cyclical factor” into its daily onshore CNY parity price formula, and has pushed up the cost of shorting the yuan by draining offshore liquidity, an advisor said, requesting anonymity. One-year offshore USDCNH swaps narrowed by 500 pips on Monday afternoon. On Tuesday the CNH Hong Kong Interbank Offered Rate (Hibor) surged to a high not seen since 2018.

The offshore liquidity crunch was likely driven by issuance of CNY35 billion in PBOC bills, when only CNY25 billion were set to mature this month, eating into the CNH900 billion pool of offshore deposits, a Hong Kong FX trader said. The widening gap between the CNY and CNH onshore and offshore rates has also driven arbitrage, draining CNH liquidity, he explained, adding that tight conditions are set to persist with signs of large state-owned banks selling dollars offshore.

In the short term, there is strong support for the onshore rate at around 7.3, and particularly at the 14-year low 7.3280 while offshore support is likely to hold at the record weak level of 7.3746 seen in November 2022, he said.

JACKSON HOLE EFFECT

However there is a danger any post-Jackson Hole rally in the dollar index above 104 could push USDCNY to 7.36, opening the door to 7.40-7.50, he said.

Both USDCNY and USDCNH broke 7.30 on Aug 15 when the PBOC cut the medium-term lending facility and 7-day reverse repo rates by 15 and 10 basis points. The rate reductions widened the U.S., China rate spread to about 170bp, accelerating capital outflows, the advisor said.

The PBOC has prioritised economic growth over the yuan, though the impact of the 10bp rate cut will be limited while credit demand remains low, he observed.

DOMESTIC DRIVERS

Yuan weakness since May has been largely driven by sluggish economic and credit indicators, property company debt defaults and a lack of stimulus, the advisor said, noting that DXY only stood at 103 on the most recent occasion USDCNY weakened past 7.30, compared to 110 when it broke 7.20 last year.

The PBOC has set stronger-than-expected daily fixings since the end of June, and strengthened its efforts this week, with Tuesday recording a gap with market expectations as wide as 1,111 pips.

A Shanghai FX analyst told MNI the PBOC likely restarted the counter-cyclical factor at the end of June, but at a weaker pace than between Sept-Nov 2022, when USDCNY also dropped below 7.30. While a weaker yuan should benefit exports, the effect would be limited, with a 10% depreciation boosting overseas sales by only about 5%, he argued.

But interviewees agreed USDCNY will likely gain ground toward 7.0 in the fourth quarter as more policy support takes effect. Zou Lan, head of the monetary policy department at the PBOC, told reporters this April that the CFETS RMB index, which measures a basket of currencies from China's 24 major trading partners, had remained stable at about 100. (See MNI: Yuan Seen As High As 7.0 After PBOC, Politburo Moves)

PBOC officials rarely give specific public yuan levels, so the 100 level is meaningful, the Shanghai analysts said. The index has now moved to 97, so room existed for CNY to strengthen this year, one analyst added.

The central bank set a strong tone in its latest monetary policy report that it will “resolutely guard against any overshooting of the yuan exchange rate”. The analyst predicted the regulator would unveil more tools as necessary, such as a cut in forex reserve requirements. (See MNI BRIEF: PBOC Eases Rules On Capital Inflow To Curb Weak CNY)