Many have been quick to speculate that the recent move by the People’s Bank of China to scrap the 20 percent reserve requirement for trading foreign currency forwards is a signal that the government intends to depreciate its currency. That narrative was strengthened on Tuesday as the PBOC lowered the yuan fixing rate by the most in eight months.
One can probably assume that the PBOC wants to slow the recent pace of currency appreciation, which saw the yuan reach its strongest level since December 2015, but I would caution about misunderstanding the government’s intentions.
What is more likely is that the PBOC believes capital flight risks have diminished, as evident by the recent rise in foreign-exchange reserves, and the policy of yuan liberalization can continue at a slow and steady pace.
Sun Guofeng, head of a PBOC-affiliated financial research institute, was quoted in Caixin as saying the “adjustment was made as the current market environment has changed greatly, which means counter-cyclical macro-prudential policies have given way to a neutral monetary policy.” Sun added that “academia and market participants are in agreement that currently the yuan’s exchange rate reflects economic fundamentals and is generally at a reasonable equilibrium level.”
Sun’s point on the market environment is pertinent. The reserve ratio on currency forwards was introduced in October 2015 in an attempt to temper yuan depreciation following the adjustment in the daily fixing rate. To be clear, the PBOC has not scrapped the reserve requirement rule, but simply reduced the reserve deposit back to zero. If the PBOC wants to curb dollar demand in the future, it can always raise the ratio again.
In addition to normalizing policy, lowering the reserve requirement will have some positives for China’s capital markets. The move should narrow the spread between offshore and onshore forward prices on the currency, allowing users of the China Stock and Bond Connect programs to hedge their currency risks more cheaply and easily. Interestingly, foreign flows into Chinese stocks and bonds have been increasing recently, with Shanghai Stock Connect inflows reaching a one-year high at the end of Aug. 30, while Bond Connect transactions hit new highs last week.
The PBOC would like to see more two-way volatility in the currency. The yuan was viewed last year as a one-way negative bet, while this year has been marked by steady appreciation as a result of U.S. dollar weakness, China’s positive economic performance, and restrictions placed by the government on capital outflows. Those factors will likely continue to support a stable yuan for the rest of the year. Note that Chinese Premier Li Keqiang said this week that China’s economy will maintain its momentum, and that officials won’t seek to boost exports by devaluing the yuan.
Finally, with the Communist Party’s twice-a-decade leadership congress due to start on Oct. 18, and U.S. President Donald Trump potentially making his first visit to China in November, it’s hard to see the political motivation for the government to push for further yuan weakness.
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