Remember back in late May and early June when the PBoC engineered a pretty epic short squeeze in the yuan?
If not, that’s ok. Here’s what happened. When Moody’s downgraded China for the first time since 1989, it was readily apparent that Beijing wouldn’t just take it in stride and go on about their business.
See if you are a Chinese citizen and you go out and you do something that Beijing thinks could destabilize markets (or destabilize anything really), they will simply arrest you. Of course that’s not as easy if you’re not a Chinese citizen and it’s harder still if the offender is both not a Chinese citizen and not an individual person.
So the Politburo couldn’t arrest Moody’s (much to the Party’s chagrin) which means they had to do the next “best” thing: publicly shame the ratings agency by calling the downgrade absurd and then simply intervene in markets to control the fallout.
Well, this all unfolded just as the onshore yuan spot was deviating routinely (to the weak side) versus the fix and as the fix was routinely set higher than the strongest analyst forecast. Which means China needed that Moody’s downgrade about like they needed a fucking hole in the head.
The pattern of stronger-than-expected fixings represented the PBoC scrapping (or at least temporarily sidelining) the market’s role in determining how the onshore yuan trades. The last thing you want if you’re already destabilizing everything from the bond market to the stock market to commodities by squeezing your elephantine shadow banking complex, is for the currency to go into free fall again because then you’d have to add “accelerating capital flight” to the list of fires you’re trying to fight.
Propping up the yuan was a policy priority in 2017 as Chinese authorities tried to stanch capital outflows and prevent financial shocks prior to the Party Congress. At the same time, a weaker currency could help to shore up the economy if the tightening effort ends up choking off growth.
As usual, this is an impossible tightrope act – it’s a game of Whack-a-mole. Every problem you “solve” creates another problem and the only way to “solve” the new problem is often to un-solve the old ones.
Well anyway, the PBoC ended up just “fixing” the fixings with what they called a “counter-cyclical adjustment factor” which was added to to the calculation of the daily reference rate. Here, in bullet points, is how that worked (via Bloomberg from last summer):
- China plans to change the way it calculates the yuan’s daily reference rate against the dollar, adding a “counter-cyclical adjustment factor” that may blunt the impact of big market swings, according to people familiar with the matter.
- Under the new formula communicated to banks by the PBOC this week, institutions that provide quotes for the fixing will take into account the previous day’s official closing price at 4:30 p.m.local time, the changes in baskets of currencies, and the counter-cyclical adjustment factor
- Banks are currently tweaking and testing their fixing models and will start to provide quotes using the new fixing formula soon, people say
- Under current conditions, new formula would partly filter out the impact of excessive volatility in the spot market by reducing the closing price’s role in the next day’s fixing, people say
- People asked not to be named as the matter is private
And here’s how China “explained” it:
China’s foreign-exchange market can be driven by irrational expectations, resulting in unreal supply and demand that increases the risk of overshooting. The counter-cyclical factor may ease herd actions and help guide investors to pay more attention to economic fundamentals.
So, basically, on days when the PBoC thinks the spot rate is “irrational” they will not only intervene by selling dollars, they will also simply set the next day’s fix wherever they think it needs to be to compensate for your fucking “unreal, herding actions” during the previous session.
Again, all of that unfolded in late May/early June.
The yuan staged an epic rally on the heels of that move and ultimately, the PBoC tried to put the brakes on what they started when, in early September, the relaxed the rules on forwards (specifically, they cut a reserve requirement on FX forwards that was originally put in place in the days following the August 2015 devaluation) thus effectively letting the market drive the yuan a bit lower.
For a minute there, the yuan sold off, but as we’ve documented over the past couple of weeks, it’s rallied further and headed into Tuesday was sitting at a four-month high or, more simply, at its highest level since the reserve requirement was removed in September.
Well guess what? The PBoC had apparently seen enough yuan strength for the time being because overnight, Bloomberg reported that they’ve scrapped the counter-cyclical adjustment factor.
“China’s central bank has made a change to the regime used to manage the yuan, effectively removing a component used by banks to calculate their submissions to the currency’s daily reference rate,” Bloomberg writes, citing people familiar with the matter, before adding that “The People’s Bank of China recently told some lenders that contribute to the rate — known as the fixing — to adjust their use of the “counter-cyclical factor” in such a way that it would have no impact on the mechanism.”
Ok, so here’s the annotated chart that captures everything said above:
To be sure, this wasn’t all that hard to see coming. Again, the yuan was at a four-month high against the dollar and as you can see from the chart, that means it had effectively erased all of the losses engineered by the PBoC in early September when the reserve requirement on FX forwards was dropped. Further, the dollar is in a tailspin, coming off its worst year in more than a decade and riding a three-week or a four-week (depending on if you’re using DXY or BBDXY) losing streak.
Also, think about how things are going with regard to China’s reserves. On Sunday, the PBoC said end-December FX reserves were $3.14 trillion against estimates of $3.1268 trillion. So that’s the 11th consecutive monthly increase.“It’ll be tough break the virtuous circle of a softer USD facilitating growing China reserves which then supports the yuan, and that in turn helps weigh on BBDXY,” Bloomberg’s Mark Cranfield wrote on Sunday. This comes thanks in no small part to tighter capital controls.
Set against that backdrop, the move to drop the counter-cyclical adjustment factor makes sense. They really don’t need it thanks to the above-mentioned “virtuous circle” and generalized dollar weakness. The PBoC hiked OMO rates (slightly) following the Fed hike in December, but hell, they really needn’t have worried. The market read the Fed as dovish.
Today’s decline in the offshore yuan is the steepest since the FX forwards news in September. Have a look:
“This is not surprising as the expectation for depreciation has waned,” Australia & New Zealand Banking Group’s Raymond Yeung, told Bloomberg. “This suggests that the authorities expect to see the exchange rate to float within a reasonable range in the near term.”
As Sue Trinh, RBC’s head of Asia FX strategy said today, 6.50 looks like the “pain threshold” for yuan strength for the PBoC “when USD/CNY fell below the level in September, it was swiftly followed by an RRR cut by the PBOC, which made it cheaper to short the yuan and caused the cross to snap back.”
“While today’s report has not been officially confirmed (the PBOC responded to media request by simpy saying that the countercyclical factor depends on banks’ CNY fixing submissions), it is consistent with the recent pattern of observed countercyclical factor, which has remained very muted,” Goldman writes this morning, adding that “even over the last couple of months, the amplitude of the countercyclical factor seems to have been decreased over time.”
Of course this also “suggests” that China was concerned about the message the counter-cyclical adjustment factor was sending with regard to the PBoC’s tight grip on the FX regime. “If the report is correct, in our view, it could suggest that the authorities are ready to allow the CNY to be more market-determined,” Goldman goes on to say.
So there you have it. Make of all that what you will. It’ll be interesting to see if China ends up dusting off the CCA factor later this year if another Fed hike (or two) ends up shoring up the dollar and moving rate diffs back in favor of the greenback.