MNI Source: PBOC to Keep Grip On Yuan For More Than A Decade

--Yuan May Trade At 6.5-6.6 Against U.S. Dollar By End-2017

--M2 May Rise As Much As 10% y/y In 2018

--GDP May Expand 6.5% In 2018

--Deleveraging May Ease Somewhat in 2018

--China Won't Necessarily Follow Fed Rate Hike

     BEIJING (MNI) - China is unlikely to ease controls over the value of its

currency or allow free capital outflows for at least a decade for fear of a

possible massive exodus of money, a senior official close to the People's Bank

of China told MNI.

     The central bank will also keep the value of the yuan in a strict range of

between 6.5 to 6.6 against the U.S. dollar until at least the end of this year

to support exports, the official said in an interview last week, declining to be

identified because of government policies against officials making unfiltered

comments. 

     Echoing PBOC Governor Zhou Xiaochuan, the source said the central bank

doesn't consider now to be the right time to relax its hold over the exchange

rate or to reform the rate-formulating mechanism, which takes into account FX

market demand, the rates on a basket of other major currencies and the so-called

counter-cyclical factor -- essentially an undisclosed "X" factor the central

bank uses to reduce price swings.

     "The yuan is still facing depreciation pressure, so the counter-cyclical

factor is needed when the yuan exchange rate sees sharp volatility driven by

irrational herd effects," the official said. "The priority for exchange-rate

policy this year is maintaining basic stability," he stressed.

     The currency has shown unexpected strength this year, gaining 4.52% against

the dollar versus a 7.02% drop last year. Despite some analysts predicting it

would weaken past the psychological mark of 7 against the U.S. dollar, it has

rebounded, strengthening to as high as 6.4350 this year. 

     Some prominent academics and former government officials in China have been

calling for the liberalization of the exchange rate, saying that now is the best

opportunity to push forward the yuan's "internationalization" through liberal

reforms of the currency. But the official MNI talked to dismissed the argument

for the liberalizing move.

     "The two elements in the liberalization process -- a completely

free-floating rate and convertibility of the capital account -- are not likely

to take place for at least 10 years," the official said. 

     A free-floating exchange rate could lead to a sharp depreciation of the

currency, and full convertibility could encourage an exodus of capital, such as

illicit incomes, which might lead to social and financial chaos, the source

said.

     "That is why the regulator has a tight grip on forex reserves, even as the

size seems enormous and excessive relative to what the country needs conducting

normal trade," the source said. 

     China's foreign-exchange reserves in October saw the ninth straight monthly

increase to $3.1092 trillion, the highest level in a year.  

     Having $3 trillion in forex reserves allows the bank to step in to stem any

surge in capital outflows, with the central bank preferring to maintain a

significant buffer, the source said.  

     On the government's deleveraging campaign in the financial sector,

financial tightening measures next year won't be as "harsh" as they were this

year for fear they could harm the economy, the official said. As a result, broad

monetary supply (M2) may accelerate next year, partly due to the lower base of

comparison this year, the official said. Year-on-year growth of the M2, which at

8.8% last month was the lowest ever, may rise well above 9% or even break 10% in

2018, the source said.

     The source contended that M2 is no longer a fair indication of the real

economy's demand for liquidity. The sharp drop seen this year has reflected a

reduction in deposits by non-banking institutions, a result of the deleveraging

campaign, he said.

     This is in line with the third-quarter PBOC Monetary Policy Report released

late Friday, in which the central bank explained that the relevancy and

predictability of M2 data had declined, while recent financial deleveraging had

further slowed M2 growth.

     According to the PBOC report, the weighted average lending rate picked up

to 5.76% in the third quarter, rising 9 basis points from the second quarter.

The interest rate on general loans picked up by 15bp to 5.86%, while the average

mortgage rate rose by 32bp to 5.01% in the third quarter, about where it was in

2015. 

     Market interest rates will remain at a high level for another couple of

months given the ongoing deleveraging, keeping bearish pressure on bonds, the

source noted. 

     The rise in China's market rates this year means China's interest rate has

already risen relative to the U.S., so even if the Federal Reserve hikes its

rate next year, China won't necessarily follow, the official said.

     However, the sources noted that China needs to further optimize its

interest rate formation mechanism. 

     "Unlike in the U.S., in China, our push for an interest rate corridor is

still in the trial stage," the source said. 

     Under the PBOC's trial system, the policy target is the pledged seven-day

interbank market rate of the deposit institutions as a benchmark, while the

rates on Standing Lending Facility (SLF) instruments and excessive deposit

reserves constitute the upper and lower bounds of the corridor, respectively.

The central bank will align the policy rate target with their desired levels via

open-market operations.

     Policymakers are still discussing which rates should be permanently

employed, the official said.

     Meantime, the source said, economic growth next year will likely slow to

6.5% given that weakness in investment has not been matched by gains in

consumption. China is also not ready to rebound from the so-called "L-shaped"

stalled growth, he said.

     China has ways to prop up growth via investment, but has to weigh deploying

that strategy against certain consequences, such as prolonging financial risks

and compromising its goal of cleaning up the environment, the source said. 

     The widening gap between the consumer price index and producer price index

means that downstream demand remains sluggish and that the service sector has

yet to catch up, he said. 

     The Chinese government, with strong control over virtually every aspect of

the country, is powerful enough to prevent a so-called Minsky moment, or a

sudden major collapse of asset values sparked by debt or capital flight risks

posed by local government borrowing and rising household debt, according to the

source.

     "China will never allow widespread bankruptcy that can lead to

instability," the official said. "That said, we still need to take heed of the

risks and address financial bubbles in case they damage the real economy," he

said.

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

--MNI Beijing Bureau; +86 10 8532 5998; email: william.bi@mni-news.com

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

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