On Tuesday morning the People's Bank of China announced reforms to its daily USD/CNY mid-point fixing mechanism. Market makers will have to take into consideration overnight global developments as well as the previous trading day's USD/CNY closing level to provide a USD/CNY mid-point before the market opens. The central bank will reference the market makers' reported levels before announcing the daily mid-point.
Paul Mackel (HSBC)
Why has the USD-CNY fixing mechanism been changed?
The fixing reform announcement is in line with our expectations. Most recently we discussed how the RMB can transition into a freely-floating currency, and one of the two key developments is through changes to the USD-CNY reference rate. It has been our view that the fixing should cease tracking the USD and be less influenced by the PBoC, but more market-determined. To achieve that, the fixing process needs to become more transparent.
The PBoC has provided its reasons for the timing of the exchange rate reforms. We agree that exchange rate reforms are complementary with ongoing capital account liberalization measures. As more capital flows go through the onshore FX market, the PBoC will find it harder to manage the USD-CNY exchange rate. We have been arguing that Beijing should not fear floating the exchange rate. With China's low currency mismatch and its potential to eventually borrow abroad largely in RMB, the risk of financial instability stemming from currency depreciation and volatility is low and falling.
In our view, there could be another important consideration behind today's announcement. We believe the PBoC is accelerating reforms to raise the chance of the RMB's inclusion in the IMF's SDR basket.
Although it is not explicitly mentioned, it is nevertheless understood that a reserve currency cannot be a highly managed one, which could potentially deviate from its underlying fundamental value thereby resulting in eventual instability. That was indeed the risk for USD-CNY, which has been held very steady, despite ongoing capital outflows from China. We note that the PBoC also pledged further FX reforms - such as the extension of the CNY trading hours and promoting convergence between the onshore and offshore exchange rates - in their Q&A which are important in the technical considerations of potential RMB inclusion in the SDR.
What are the economic implications?
Today's announcement has generated some weakness in the RMB, and as our FX team discussed above, further weakness/volatility cannot be precluded in the current market conditions. However, the announcement should not be seen as a sign of active policy-driven devaluation to boost exports. Exports have indeed been soft so far this year, contracting 0.6% year-on-year in the first seven months. But this is largely a reflection of sluggish external demand. Regional manufacturing economies, from Taiwan to Korea, have also seen sharply weaker export growth so far in 2015. In an environment of a soft global recovery, the benefits of beggar-thy-neighbour competitive devaluation are neither clear nor easy to reap. It also goes against policy makers' long-held goal of promoting greater international usage of the RMB for trade and investment purposes.
And China's policy makers have sufficient policy ammunition to boost domestic demand to offset the external headwinds. There are certainly challenges, ranging from an uncertain property market recovery to weak investment growth. But both monetary and fiscal policies are becoming more accommodative and better coordinated, as evidenced by the latest reports that policy banks will issue more than RMB1 trillion of financial bonds to support infrastructure investment. Given the fragile foundation of the recovery, additional easing measures are still needed in the coming months. Real interest rates have risen significantly for the corporate sector in 2015 on the back of continued deceleration of PPI inflation. Therefore there is still room to lower policy rate further. Cuts to the reserve requirement ratio will also be needed to offset the impact of slower FX inflows on base money growth. We forecast an additional 25bps policy rate cut and 200 basis points reserve ratio cut in 2H 2015. The combination of monetary and fiscal policy support should help ensure that the economy remains on a path of cyclical recovery, and achieve the growth target of around 7%.
What does today's change for CNY mean for the region's currencies?
We have already seen a large knock-on effect for the region's currencies. With the announcement of the sharp move higher by the USD-CNY fix, the rest of USD-Asia initially lurched higher. USD-Asia should trade with heightened sensitivity to USD-CNY's movements, at least until onshore spot finds a better sense of its equilibrium level. In particular, Asian currencies such as the KRW, TWD and SGD are seen as being more sensitive to China's FX policy compared to other currencies in the region. Given we believe that China is not aiming to engineer a much weaker RMB, the sharp depreciation pressure on Asian currencies from today's CNY fixing change should fade. That said, we believe the likelihood of USD-RMB trading with elevated volatility implies that other USD-Asian exchange rates should be more volatile too.
The next couple of days will be watched closely. We believe PBoC will let the fix adjust further to market forces, albeit more gradually. Meanwhile, the central bank could also smooth the upside in onshore USD-CNY spot to prevent it from overshooting and ensure market order. Eventually, USD-CNY should gradually settle at a new equilibrium level. The FX forward points have moved higher following the spot move, but should gradually ease once spot USD-CNY makes enough of an adjustment to meet a better sense of demand and supply. With our view that more monetary policy easing is coming and capital account liberalization will continue, the FX forwards should better reflect interest rate parity.
Khoon Goh (ANZ Research)
Today's move by the People's Bank of China (PBoC) to liberalise the RMB exchange rate mechanism serves two purposes, in our view. Firstly, the exchange rate reform can partly be seen as a measure to strengthen the case for RMB's inclusion in the SDR basket later in the year. By changing the way the central parity rate (ie the fix) is set, from one that is determined by the authorities to one that is more closely based on the onshore spot rate, it ensures that the new fixing reflects actual market realities. When the fix was first introduced in 2005, it was an important signalling tool used by the PBoC to manage market expectations. But in recent times, the fixing has largely lost its relevance as the onshore spot rate has consistently deviated from the fix throughout this year.
In addition, the IMF Staff Report on the SDR review raised the issue of the appropriate exchange rate to use for SDR valuation purposes, should the RMB be included. The IMF's preference was for a rate based on intraday market trades; hence the shift in the fix overcomes this issue. Secondly, the one-off devaluation is to help ease financial conditions, in light of the weakness in the export sector. If the PBoC's intention were purely to align the fix to the onshore spot rate, then today's fix would have just moved towards where the spot was trading (ie 6.2097). The fact that the fix was set at 6.2298, lower than the closing spot rate, is a signal that the authorities want a weaker currency. The PBoC's statement today mentioned that the RMB's real effective exchange rate is relatively strong, which is not entirely consistent with market expectation.
While the PBoC says that today's fixing is a one-off adjustment, the big question is how far the authorities will tolerate further RMB depreciation. We note that the PBoC statement mentions the need for some time for the market to adapt to today's change, so we suspect the PBoC will ensure the markets do not get too carried away. But there is a fine balancing act for the authorities to manage, to ensure that depreciation expectations do not become entrenched, which will lead to a pick-up in capital outflows and further RMB depreciation. Going forward, more RMB reforms are forthcoming, with the market set to play a bigger role in exchange rate determination, including extended FX trading hours, introducing qualified foreign institutions and promoting the formation of a single exchange rate in both the onshore and offshore markets. In this regard, it looks to be only a matter of time before we get full convergence between the onshore and offshore spot rates. In short, we are getting closer towards a free-float of the RMB. In addition, now that the fix will be close to the onshore spot rate, band widening is probably not too far off.
MORE PRESSURE ON ASIAN CURRENCIES
The stability in the RMB over the past few months, in the face of a stronger USD, had helped to serve as somewhat of an anchor for the region's currencies. With today's move, this is clearly no longer the case. With the devaluation of the currency and a move towards a more market determined exchange rate, the risk is that we could see some more RMB weakness which will pressure Asian currencies lower.
Haibin Zhu, Grace Ng, Marvin M Chen (JPMorgan)
The possible reasons behind the policy actions are as follows.
First, the strong CNY appreciation in real effective exchange rate (REER) term has put a lot of pressure on China's exports. From June 2014 to July 2015, CNY has appreciated in REER term by 12%, mainly because of USD appreciation. In the first seven months of the year, exports declined by 0.6% compared to the same period of last year, and July export growth registered a disappointing decline of 8.3%oya. Going forward, the currency appreciation will continue to drag on export growth. It is unlikely that China will achieve the 6% trade growth target for this year.
(MORE TO FOLLOW) Dow Jones Newswires
August 11, 2015 03:33 ET (07:33 GMT)
Second, today's announcement is a responsive action to the recent trend of weakening currency (against USD) in the region. EM Asia central banks seem to welcome the gradual narrowing of interest rate differential that should lead to modestly paced capital outflows, thereby weakening local currencies against the USD and providing much needed relief to external competitiveness. In the past three months, Malaysia Ringgit depreciated against USD by 9.4%, followed by Korean won (7.2%), Thai baht (4.6%), Singapore dollar (4.2%), Taiwanese dollar (3.2%) and Indonesia rupiah (3.0%).
Third, we think it is a responsive action to last week's IMF SDR review report. In the report, the IMF staff criticized that the central parity rate is not an appropriate reference exchange rate to be used in SDR calculation, in that the discrepancy between daily fixing and daily spots suggests that the daily fixing is not based on actual trade. The report indirectly suggested that the PBOC's central parity rate should be responsive to changes in market condition. Today's action, especially the statement that the central parity rate will align more closely with the closing spot rates on the previous day, suggests that the PBOC is moving towards that direction. Interestingly, the PBOC statement said the strong RMB in REER term "is not entirely consistent with market expectations." In addition, in today's statement the PBOC also promised to enrich FX products and promote the convergence between onshore and offshore exchange rates (these issues were also raised in the IMF report).
However, today's policy action leaves a lot of questions unanswered.
First, how the FX market will respond to the announcement. The spot rate of CNY/USD jumped to 6.32 this morning, and the discrepancy between the fixing and spot rates remained almost unchanged.
Second, whether today's announcement will strengthen the CNY depreciation expectations in the market, and by extension whether capital outflows will intensify. China has witnessed large capital outflows in the past 4-5 quarters ("China: the myth of capital outflows", July 28). Some of the capital outflows were driven by corporate balance sheet adjustment, but the unexplained component (adjusting for corporate balance sheet adjustment, net FDI, RMB internationalization) was sizable.
Third, whether the PBOC will truly let the daily fixing to move along with daily spots, or some form of intervention will remain.
We see two possible scenarios for the CNY outlook.
In the first scenario, today's move represents a regime-shift in China's exchange rate system. Going forward, the PBOC will set the central parity rate based on the closing spot rate on the previous day. Technically, this means CNY will become a freely floating currency. Given the current market expectation, we expect CNY will depreciate in the near term in this scenario, and daily fixing will drift up until the market reaches balanced two-side volatility.
In the second scenario, the PBOC will try to re-anchor market expectations. That means the PBOC will sell USD in the spot market to prevent daily spots shifting away from the new central parity rate. Daily fixing will stay stable in the coming weeks. In this scenario, the intervention in the FX market will imply a further decline in FX reserve, affecting base money creation on the domestic front. The PBOC will need to cut RRR, or inject liquidity through alternative measures, to prevent unintended credit tightening or rising volatility in interbank rates (as the latest Monetary Policy Operational Report pointed out, interbank rates are an important part of the price-based monetary policy operation).
The movements in CNY spot and fixing rates in the next few days are very important to assess which of the two scenarios will materialize.
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August 11, 2015 03:33 ET (07:33 GMT)
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