The Art Of Currency And Trade War: Inside China’s Thinking On The Yuan

… there is no big problem with the yuan depreciation. It could be beneficial as the economy is slowing. We are able to control capital outflows. There is no need for aggressive intervention.

That’s from one of three anonymous sources Reuters spoke to for a story about the PBoC’s thinking when it comes to rapidly weakening Chinese yuan.

On Tuesday, hours after a sharp early decline in the yuan through 6.70, PBoC Governor Yi Gang attempted to calm things down by assuring everyone that he’s “paying close attention to that”. The yuan’s weakness, he said, is “mainly due to factors such as a stronger dollar and external uncertainties.”

Those comments followed remarks from PBoC deputy governor (and SAFE head)  Pan Gongsheng, who told a conference in Hong Kong that China has plenty of FX reserves and other FX “tools” and is “confident” that they can keep the currency stable.

It’s pretty clear what’s going on here. China is letting the market weaken the yuan because a weaker currency helps cushion the blow from the trade tensions. The combined threat of a decelerating economy and a protracted trade war of attrition with the U.S. has led authorities in China to deemphasize the deleveraging push and loosen monetary policy. Easier policy contrasts with tighter monetary policy in the U.S., and that growing policy divergence weighs on the currency.

As the Reuters source quoted here at the outset notes, the PBoC is just fine with that to the extent it helps the economy amid the trade tensions and as long as policymakers are confident they can control capital flight. For my part, I’ve variously suggested that eventually, they’ll claim the market has overreacted and use that as an excuse to sell U.S. debt, thereby accomplishing two things at once: they’ll have weakened the yuan and weaponized their Treasury holdings, all while retaining plausible deniability.

Of course the official line is that they won’t “weaponize” the yuan, but as we’ve seen over the past several weeks, they don’t have to: the market is doing it for them and because they have the flexibility to lean on RRR and OMO cuts, they can effectively create a policy divergence while claiming they are pursuing “prudent” monetary policy in the face of economic reality.

On Wednesday, the yuan rose again, as traders take a pause to reassess the situation:


Although policy banks were reportedly seen conducting small scale interventions on Tuesday, Reuters’ sources say there’s no immediacy here. To wit:

On Tuesday, as stocks sank and the yuan fell through a key psychological level of 6.7 on the dollar, traders said state-owned banks, which sometimes act on behalf of the central bank, made efforts to prop up the currency.


“Policymakers believe some yuan depreciation is okay, but they don’t want to see it falling below 6.9. Appropriate currency depreciation is needed given that the economy faces downward pressure,” one policy insider said.

That underscores the contention of Deutsche Bank’s Alan Ruskin, who earlier this week downplayed the notion that 6.70 was in fact the line in the sand.

“There has been much talk about 6.70 being a line in the sand, but what’s so special about 6.70?,” Ruskin asked, in a note dated Monday.

“The destabilizing aspects on the speed of the FX move, make a much stronger case for more intervention than the 6.70 level, especially while the CFETS is solidly above its 2017 average,” he added.

Again, it’s the pace of the deceleration that matters, not so much any magic number.

Let’s take a trip down memory lane here for a minute. Here’s one of my all-time favorite characterizations of the 2015 devaluation from BNP’s Mole Hau (I think he may be at ICBC now):

Whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, (thus) the role of the market in determining the exchange rate has, if anything, been reduced in the short term.

Well last summer, when the yuan was sitting around 6.90, the PBoC introduced a laughably opaque “counter-cyclical adjustment factor” designed to engineer a short squeeze in the yuan, perhaps in an effort to placate Trump. That amounted to a rolling back of whatever liberalization was ostensibly embedded in the “new” FX regime that went into effect in August 2015. Effectively, they went back to manipulating the fix to control the spot but they also retained the discretion to intervene in the spot market (and they subsequently did), which effectively meant that last summer, they were manipulating the fix and the spot and because the latter informs the former, the whole thing was fixed.

That led directly to a historic rally in the yuan versus the dollar that ran so far, so fast Beijing ultimately had to put the brakes on the situation in early September by relaxing rules on forwards put in place following the 2015 devaluation.

Here’s an annotated chart that shows you how things have played out for the yuan. Note the (successful) attempt to engineer a short squeeze last summer with the addition of the counter-cyclical adjustment factor, the (initially) successful attempt to put the brakes on the rally by relaxing rules on forwards in September, the (not so successful) effort to put the brakes on post-September yuan strength by sidelining the counter-cyclical adjustment factor that was used to start last summer’s short squeeze, and the recent weakness:


For their part, BNP seems to agree that if there is a “line in the sand”, it’s somewhere well above 6.70. Here’s what the bank wrote in a note dated Tuesday:

Above 6.70, the possibility of the intervention is also much higher than in the previous 6.50-6.70 range, more so given Governor YI Gang’s comments mentioning ‘cyclical behaviour’ in the FX market and reasserting the target of FX stability. What to do now? We expect the next key resistance at 6.85, the level at which PBoC introduced the countercyclical factor back in May 2017. However, those who still want to go long USDRMB may face a bumpy and risky path given PBoC’s potential actions. For those who want to short USDRMB, it’s recommended to wait for that level, so as to be safer and have PBoC’s support.

Interestingly, Reuters’ sources say that China could go back to leaning on the counter-cyclical adjustment factor in the event things worsen from here.

Beijing is also expected to make use of other tools it has finessed since 2015, such as the “counter-cyclical factor” it introduced in May last year to the formula it uses to determine the mid-point reference rate for the yuan’s exchange rate against the dollar each day. That factor was designed to curb speculation and volatility in the yuan.

“The authorities have become more experienced in managing the currency,” said a third source who advises the government. He expects some form of intervention in the 6.7-6.8 area.

“Currently, the pressure is not as big as in 2015 … if the depreciation trend continues like this, they could take some measures, including reviving the counter-cyclical factor, rather than heavy spending of foreign exchange reserves.”

Underscoring all of that is APAC economist Mahamoud Islam who told Reuters that this time is indeed different because the PBoC can “can reintroduce the counter-cyclical factor, they can tighten capital controls [and] in the end they can even use a small amount of their reserves.”

Right. So they can pretty much do whatever the hell it is they want to do. They have so many different levers to pull here in the service of achieving the same end that it would be well nigh impossible to definitively say which came first, the “irrational” market behavior or the intervention. And that’s probably the point. Whatever they do in terms of intervening and however weak they allow the yuan to fall before they do intervene, they’re going to be able to plausibly claim that it’s the market and not an express desire to, on the one hand, weaponize the yuan by weakening it or, on the other, weaponize the country’s enormous pile of U.S. debt by selling it to stabilize the currency.

Good luck sorting this out and trying to point fingers, Steve Mnuchin.



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