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From Fixing to Signaling, How China Manages the Yuan: QuickTake

August 08, 2019

Editors note: This article shows how the Chinese yuan is manipulated every day. Commentators who discuss which direction the yuan would go in a free market are not fully informed because the free market is not relevant to its exchange rate.

The U.S. accused China of manipulating its currency after the yuan tumbled to an 11-year low in early August -- a hefty charge. Monitoring how the People’s Bank of China handles its “managed float” system for the yuan isn’t easy; the central bank has various tools at its disposal, some public, some hidden. Its thinking is essentially unknowable to outsiders. But there are ways to observe some of the levers it pulls to influence the currency. These are some of the most-watched:

[Richard Frost | August 8, 2019 | Bloomberg]

Daily Fixing

The most obvious way the PBOC influences the currency is by setting a reference rate each trading day at 9:15 a.m., known as the daily fixing. The yuan is then allowed to move 2% in either direction. The rates are calculated with formulas that take into account such factors as the previous day’s official close at 4:30 p.m, the yuan’s move against a basket of currencies and the moves in other major exchange rates. In 2017 the PBOC introduced a so-called “counter-cyclical factor” to avoid a fixing that it deems as excessively weak or strong. That was interpreted as a step back from China’s oft-stated pledge to give markets a key role in determining the exchange rate.

Liquidity Squeeze

Driving up the cost of betting against the yuan offshore has long been seen as a favored tactic to curb a decline. 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 they need for their bets. That can be achieved by having agent banks buy the currency or decline to lend their supply to other banks. The PBOC can also sell Chinese government bills in Hong Kong to vacuum up yuan. The cost for banks to borrow yuan overnight, known as Hibor, surged to more than 20% on several occasions in the past few years, most notably in January 2016 when it climbed to almost 67%. (The rate was at 1.8% on Aug. 8.) Another squeeze came in August 2018, when the cost of betting that the yuan would weaken soared amid speculation that China was restricting domestic banks’ ability to lend yuan offshore.

Regulation

The central bank also has regulatory measures at its disposal. In 2015 and 2018 the PBOC imposed a reserve requirement on some trading of foreign-exchange forward contracts -- which locks in an exchange rate for a future transaction -- effectively making it more expensive to bet against the yuan. When introducing the 20% reserve requirement last year, the monetary authority said the foreign-exchange market was showing signs of volatility amid trade frictions with the U.S.

Signaling

The PBOC’s standard line on the currency goes: “The yuan will be kept basically stable at reasonable, equilibrium levels.” But Chinese officials aren’t averse to talking their currency up or down when they feel it’s needed. On Aug. 6, the central bank said it won’t depreciate the currency to be competitive. In May, Guo Shuqing, head of China’s banking and insurance regulator, said in a speechthat speculators “shorting the yuan will inevitably suffer from a huge loss.” A year ago PBOC officials urged banks in a meeting to prevent any “herd behavior” and momentum-chasing moves in the foreign-exchange market, according to people familiar with the matter.

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 Chinese consumers buying insurance policies in Hong Kong, and there has been little sign of a let up. Conversely, the government has been keen to encourage inflows, and this year expanded the scope of the Qualified Foreign Institutional Investor program, one of the key channels into China.

Foreign Reserves

Finally, China has its war chest of foreign reserves, 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. More recently, the stockpile has stabilized, and rose to the highest level in 14 months in June. While the level is closely watched, a caveat: Broad gains in the dollar can lead to declines in China’s reported reserves that aren’t a result of intervention, but rather because non-dollar assets in its stockpile will have depreciated against the dollar.

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