Suddenly, just before 4 PM local time on Friday, the Chinese yuan rallied hard after spending the entire day trading weaker against the the dollar.
It was a rather abrupt about-face and as you can probably surmise from the timing, this was state intervention via policy banks, likely designed to influence the next fix.
Remember, this whole thing is to a certain extent absurd. Let’s take a trip down memory lane for a moment. 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.
In the summer of 2017, 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 in the summer of 2017, 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 2017 by relaxing rules on forwards put in place following the 2015 devaluation.
On August 24 of this year, the PBoC reinstated the counter-cyclical adjustment factor, which means now we’re back to a scenario where they’re manipulating the spot and the fix. That’s what apparently went on late Friday. They’re selling dollars to influence the official close (at 4:30 PM), which is in turn a factor used to set the reference rate for the next day.
The move came as the currency pressed towards its weakest level since 2008 and amid rampant speculation that a 7-handle is just around the corner.
Whether or not a 7-handle is something that policymakers are willing to risk is one of the key questions when it comes to China and how Beijing is managing the trade war.
In August, officials stepped in to arrest the currency’s slide with a series of measures designed to guard against a scenario where the yuan pushed up against 7. Specifically, Beijing reinstated forwards rules (August 3), chided onshore banks for selling RMB (August 7), moved to squeeze offshore liquidity (August 16), and reinstated the counter-cyclical adjustment factor (August 24). Here’s the annotated chart:
As ever, the question is whether capital flight will materialize. So far, China’s reserves have remained generally stable. That’s in stark contrast to the 2015 experience when Beijing immediately lost control of the situation and was forced to burn through its war chest in order to keep the pace of the devaluation some semblance of orderly.
On Friday, just before the late-day rally, PBOC Deputy Governor Pan Gongsheng tried a little verbal intervention, promising to keep the yuan “at a reasonable, equilibrium level.”
Well, as it turns out, some folks with knowledge of the PBoC’s thinking believe that Beijing will start selling reserves again if the yuan continues to push towards 7. Two sources who spoke to Reuters said “a defense of the yuan at 7 per dollar would be mounted to show investors that the authorities wouldn’t allow a runaway market.”
Here are some direct quotes from the two officials, who Reuters notes are not the final decision makers:
If the yuan falls through 7, there could be a rapid depreciation of the exchange rate. In order to avoid such a passive situation, the authorities are likely to step in the market to stabilize the yuan.
The central bank will intervene – intervene directly or indirectly. It’s necessary. The central bank has many policy tools. We cannot let the yuan fall past 7, as it would have a psychological impact on people.
This is a delicate balancing act. They need the yuan to weaken in order to cushion the blow from the tariffs. Yuan weakness from June through August went a long way towards offsetting the first two rounds of Trump’s 301 investigation-related levies and with the administration in Washington all set to ratchet up the pressure, the yuan is a powerful tool.
That said, capital flight could become a problem at some point if expectations get moving in the “wrong” direction.
GDP growth came in below estimates in Q3 and the economy is likely to decelerate further going forward in the face of the trade frictions. China is leaning on a series of implicit and explicit easing measures both on the fiscal and monetary policy front to try and shore up sentiment.
Having cleared the U.S. Treasury’s latest semiannual report, the PBoC probably has the green light to allow more weakness in the currency into year-end to offset the economic pressure if they choose, but last weekend, Steve Mnuchin suggested the Trump administration might move the goal posts on what counts as “manipulation” in order to target China.
So who knows. As Trump would say: “Stay tuned, the ratings will be tremendous.”