China’s central bank wants the currency basket to support exporters but without risking capital outflows.
The People’s Bank of China will continue to watch the yuan against a basket of major trade partner currencies rather than exclusively focus on the U.S dollar, though a response is expected after the pair broke through 7.2 on Wednesday, analysts said.
The PBOC’s focus on a stable CFETS RMB Index, which is a trade-weighted basket of 24 currencies, attempts to strike a balance between supporting exports but without too much weakness to encourage capital outflows, said China Securities chief economist Huang Wentao. He said slower export growth could weigh on the currency as less US dollars would be deposited at banks and converted into yuan.
The CFETS RMB Index’s top three currencies are the US dollar, Euro and Japanese yen with weightings of 19.9%, 18.5% and 10.7% respectively, according to the China Foreign Exchange Trade System, which is managed by the PBOC. The index fell to 101.59 at the end of last week from 102.09 the previous week.
While yuan volatility has been closely linked to the rising U.S. Dollar Index this year, the relative stability of the CFETS index shows it has been the focus for the central bank, said China Academy of Social Sciences senior fellow Zhang Ming. The index is still higher than the 95.5 that it has averaged since China’s surprise 3% devaluation of the yuan in 2015, he said.
The yuan has weakened rapidly against the dollar since it breached 7 on Sep 16. Both the CNY and CNH broke 7.2, the weakest level since 2008, on Wednesday. The yuan has fallen as US rates have been hiked aggressively, but the faster than expected slide in the yuan has prompted the PBOC into action. (see: MNI BRIEF: PBOC Faces Test as Yuan Breaks 7.2)
The PBOC announced a 20% hike in the forex risk reserve requirement ratio on forward forex sales on Monday to curb selling pressure in the forwards market. This followed early September’s cut to the forex reserve requirement ratio, which aimed to take pressure off the yuan by providing banks with more US dollar liquidity, diminishing their need to sell yuan. These operations have attempted to slow, not halt, the yuan’s slide, analysts noted. (see: MNI BRIEF: PBOC Hikes Risk RRR On FX Forwards As Yuan Weakens)
PBOC STANDS READY
The PBOC’s move to make trading in the forward markets more expensive may have been triggered by the widening gap between the yuan’s daily fix and its closing price, as well as expectations of further weakness against the U.S. dollar, said BOC International analyst Zhu Qibing.
Markets have flashed signs of a potential overshoot. The gap between the CNY closing price and the PBOC’s fixing expanded to 1.7% on Sep 23, approaching the daily limit of 2%. One-year Non-Deliverable Forwards signal further depreciation.
The PBOC has tried to counter the yuan’s weakness through its daily fix. It has set a stronger fix in the 25 consecutive trading days to Sep 28.
The PBOC intends to “increase the friction force” to avoid a one-way sharp depreciation, said Golden Credit Rating International analyst Wang Qing. Wang forecasts the yuan could fall to 7.2-7.3 against the dollar should the greenback continue to rally.
The PBOC has numerous tools to manage the yuan. It could further adjust reserve requirement ratios, reintroduce its counter-cyclical factor, issue PBOC bills in Hong Kong to drain offshore yuan liquidity, and enhance management of cross-border capital flows, Wang predicted. (see: MNI: PBOC Response May Be Needed As Yuan Breaches 7 - Analysts)
BEWARE THE CARRY TRADE
The growing appeal of carry trades is another risk for the yuan as rates in Hong Kong track U.S. rates higher.
Huang said the carry trade in offshore market has started to pressure CNH, upping pressure on the PBOC as it tries to balance ample liquidity against a steady yuan. He argues the PBOC may choose to continue easing as long as the yuan’s depreciation is less than that of other major non-dollar currencies against the greenback.