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Monitoring how the People’s Bank of China handles its “managed float” system for the foreign-exchange market isn’t easy: The central bank has various tools at its disposal, both public and hidden. Some are more transparent, like the daily reference rate; others are murky, such as the potential for Chinese authorities to secretly urge banks not to bet against the yuan in proprietary trading. As the currency declines toward 7 per dollar, the authorities are expected to review methods available to stem one-way bets against the yuan.
1. How important is the daily fixing?
It’s the most obvious tool the PBOC has to influence the currency. It sets a reference rate each trading day at 9:15 a.m. Beijing time, around which the yuan is allowed to move 2% in either direction. The rate takes into account factors including the prior day’s official close at 4:30 p.m, the yuan’s move against a basket of currencies and changes in other major exchange rates. Therefore, encouraging declines at the official close allows the central bank to set weaker fixings without sending a strong signal on policy or destabilizing markets. One way to grasp the policy signal behind the fixing is by comparing it with the market’s expectations. A reference rate that’s significantly stronger or weaker than expected is typically considered a signal from Beijing.
The fixing has gone through rounds of reform over the years, with the aim of making it more market-based and transparent. China started to allow the yuan to trade within 0.3% of the fixing against the dollar in January 2006, widening that to 0.5% in May the following year, 1% in April 2012 and 2% in March 2014. In August 2015 China devalued the onshore yuan in its most dramatic foreign-exchange reform in a decade. In a push to make the fixing more transparent, the PBOC laid out the factors that banks need to consider as they submit prices for the rate.
3. How can the PBOC guide the fixing rate?
In 2017, the PBOC introduced a “counter-cyclical factor” in the fixing formulas that commercial banks use to calculate and contribute to Beijing’s daily reference rate. The move was made to avoid a fixing that the central bank deemed excessively weak back then. The component was removed and then reinstalled in 2018, before in October 2020 lenders stopped using the factor. Market speculation of a further reintroduction to support the yuan emerged in 2022 as the fixing rates’ gap versus forecasts widened to levels that couldn’t be explained by calculations based on a regular fixing model. As of the start of September there hadn’t been any official confirmation. Some banks that submit fixing quotations were said to have tweaked their models to lean against the yuan weakness in August, without attributing the change to a reinstatement of the tool.
4. What else can the central bank do?
One of the latest tools for the PBOC is the so-called foreign exchange reserve requirement ratio that sets the amount of foreign currency deposits banks need to hold as reserves. A change allows the central bank to fine-tune foreign currency liquidity in the banking system; for example, cutting the ratio will ease the supply of foreign currency, thus propping up the yuan. The PBOC raised the ratio twice in 2021, including an increase to 7% from 5% in May that year and another one to 9% from 7% in December, before a cut to 8% in April 2022. Before those changes, the ratio hadn’t moved since 2007.
5. What about less formal measures?
Chinese officials aren’t averse to talking their currency up or down when needed. The PBOC’s standard line on the currency is the yuan will be kept basically stable at reasonable, equilibrium levels. However, in January 2022, when the yuan was at its strongest since 2018, PBOC deputy governer Liu Guoqiang said that “market and policy factors will help correct any short-term deviation from its equilibrium level.” In addition, to guide market expectations, the PBOC tends to cite statements from the China Foreign Exchange Committee, an industry organization founded by key participants of the onshore market under the guidance of the regulators. Some of the guidance from the committee can be targeted at specific trading. In November 2021, lenders were urged to review proprietary trading volume to “improve risk management”, a comment which was followed by a significant decline in onshore dollar-yuan spot trading volume.
6. What can be done against speculation?
Driving up the cost of betting against the yuan offshore was once favored as a tactic when China wanted to curb declines, such as in 2016 and 2018. The key is to mop up liquidity — Hong Kong is by far the biggest market — so that traders have to pay higher interest rates to borrow the yuan. That can be achieved by having agent banks buy the currency or decline to lend their supply to other banks. The PBOC can also increase yuan bill issuance in Hong Kong. For the onshore market, the PBOC had additional tools to boost costs for yuan bears. During the China-US trade war in 2018, when the yuan declined toward 7 per dollar, the central bank imposed a risk reserve requirement of 20% for trading forward contracts to cool down foreign exchange buying in the forward market. The rule lasted for two years until the PBOC scrapped it in 2020 after the yuan rebounded.
7. How about capital controls?
Controlling the flow of funds in and out of the country is one of the bluntest instruments. China moved to limit outflows in the wake of the yuan’s devaluation in 2015, imposing restrictions on everything from overseas takeovers by Chinese companies to consumers buying insurance policies in Hong Kong, and there has been little sign of a let-up. Conversely, the government encouraged inflows during 2021 by initiating new channels with Hong Kong for mainland investors to tap the offshore bond market and wealth management products. As the US Federal Reserve began to tighten monetary policy in 2022, Chinese state-owned companies have been asked to exercise greater caution when it comes to reviewing new overseas spending and investment plans. The central bank could also tweak the limits of overseas borrowing or lending for financial institutions and corporates; the latest such moves were seen in early 2021.
8. What about foreign reserves?
China’s foreign reserves are among the world’s largest at more than $3 trillion. Policy makers sold billions of dollars in the aftermath of the 2015 devaluation to support the yuan. While this can be a useful indicator, it is also influenced by broad gains in the dollar, which can lead to a drop in China’s reported reserves. These declines aren’t necessarily a result of intervention, but rather because non-dollar assets in China’s stockpile will have depreciated against the dollar.
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