China’s currency balancing act

Movements in the cross rate between the US dollar and Chinese yuan since early August have been a puzzle to many onshore and offshore market participants.

The pair hit an intraday low of 6.4390 in early September but rebounded quickly. While rapid currency movements and higher volatility seem to be in line with the People’s Bank of China’s (PBoC) market-driven foreign exchange outlined in its second quarter Monetary Policy Report, it contradicts the bank’s long-standing argument for maintaining the currency’s relative stability around an equilibrium level. 

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We think there are two reasons for the PBoC’s apparently contradictory behaviour. 

"Despite the merit of a weak currency, Chinese authorities are currently more concerned about yuan depreciation.”

1. The PBoC is trying to strike a balance between near-term financial stability and the long-term interests of the economy.

While it is widely acknowledged that a weaker currency bodes well for a country’s inflation outlook and debt mechanism, it could also trigger capital outflows and dent market confidence, which seem to be bigger concerns for Chinese policymakers at the present time.

2. The PBoC is currently focussing more on the stability of the CNY CFETS basket than on US/CNY.

We would expect then the Chinese authorities to continue to stabilise CNY, particularly considering the upcoming Nineteenth National Congress of the Communist Party of China (NCCPC) on October 18.

A better balance between inflows and outflows is a critical consideration for any potential relaxation in the capital account.

Stability priority

To expand our thinking: despite the merit of a weak currency, Chinese authorities are more concerned about CNY depreciation currently, as it may result in further outflows based on previous experience.

The exchange rate was positively related with non-banks’ purchasing of foreign currencies from the second half of 2015 to the first quarter of 2016, before the authorities took concrete administrative actions to constrain the outflows.

Therefore, it is a natural reaction for the officials to reduce fund outflows by stabilising the exchange rate and hence market expectations.

We believe Chinese officials view the outflows as a critical threat, as they deplete China’s FX reserves and invoke unpleasant memories of the Asian Financial Crisis.

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We think the authorities will prefer stability more than anything else in the near term, particularly as the NCCPC approaches. Moreover, the government will likely attempt to smooth exchange rate volatility.

Any relaxation in the capital account can only be implemented with the purpose of better balancing between inflow and outflow.

That said, policymakers will still need to pay some respect to the basket mechanism, so the USD/CNY will still need to follow the broader movement of the USD in the global market.

Balancing this flexible exchange rate regime against the goal of maintaining stability is still a difficult drive. As long as China wants a flexible exchange rate regime, the government can only be hands-off to some extent.

David Qu is a China Markets Economist and Betty Wang is a Senior China Economist at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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