China is about to start leaning more heavily on the counter-cyclical adjustment factor to guide the yuan. Or at least that’s what it seems like to me.
On Monday, following the PBoC’s Friday move to reinstate the rule on forwards in an effort to put the brakes on the currency’s slide, the central bank reportedly told banks to avoid “herd behavior” and not chase momentum when trading the yuan. That’s according to people who aren’t authorized to speak publicly because, well, because it’s China, and speaking publicly about what the PBoC told you in a closed-door meeting can land you in jail. There’s no punchline to that.
According to the sources (who spoke to Bloomberg), the PBoC’s “herd behavior” comments came in a pow wow on Monday between officials and the 14 banks that contribute quotes to the daily fix. The central bank made the usual assurances about having ample tools to combat speculation and reinforced the notion that China won’t subvert “market forces”.
Apparently, some bank officials present at the meeting suggested the PBoC start using the counter-cyclical adjustment factor again to “guide market expectations.”
Ok, I’m going to run through the evolution of this again because it’s critical to understand how all of this fits together, especially in light of Friday’s move to reinstate the rules on forwards and also considering that the “herd behavior” characterization is exactly (i.e., word for word) what the PBoC said last summer on the way to rolling out the counter-cyclical adjustment factor in the first place.
If you’ve already read my brief history of this, then you’ll be forgiven for skipping it, although I think it’s always worth rehashing. To wit, pieced together from several previous accounts posted here over the course of the last year:
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 currency, 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. Those rules were reinstated on Friday morning. Here’s an annotated history of this:
Last month, sources told Reuters it’s just a matter of time before the PBoC starts relying heavily on the adjustment factor again.
“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”, one unnamed source said.
On Tuesday, the latest read on China’s reserves showed a surprise gain for July, and policymakers will likely be keen on preventing the kind of panic that accompanied headlines about reserve burn in 2015. In other words, as the trade war drags on, it would be best if the headline numbers on the country’s FX reserves continued to send a benign message. One way to help ensure that’s the case is to use the adjustment factor to manipulate the daily fix in order to guide the spot market and thereby alleviate the need to intervene actively.
As multiple observers have pointed out, we are now right at the levels where the PBoC introduced the mechanism last summer and amusingly, it worked so well that they had to roll back the same forwards rules they reinstated on Friday in an effort to put the brakes on the yuan rally last September. Barclays published the following chart over the weekend, the header on which tells you what you need to know here:
“On August 3, the PBOC re-imposed a levy on FX forward sales to stem outflow pressure, which may imply less scope for the CNY to weaken in the coming days”, Goldman wrote on Monday evening, before noting that “the countercyclical factor, which has been relatively muted in the past few weeks, should provide further useful hints of the authorities’ near-term intent for the currency.”
This is something to watch out for, because again, the combination of the CCAF and sporadic intervention in the spot market ended up catalyzing one of the longest rallies in history for the yuan late last summer.