How China’s central bank will respond to the devaluation of the renminbi

© Reuters. FILE PHOTO: Chinese yuan banknotes are seen in this illustration taken on February 10, 2020. REUTERS/Dado Ruvic/Illustration

(Reuters) – The yuan has fallen 5 percent against the dollar in the past three weeks, fueling speculation about when and how the People’s Bank of China (PBOC) might act to slow the yuan’s fall.

Even against a basket of currencies of major trading partners, the yuan fell 3.6%.

The main factors behind the Chinese portfolio outflow are rising U.S. interest rates, the war in Ukraine, and a slowdown in the domestic economy caused by lockdowns in Chinese cities in response to the COVID-19 outbreak.

While most market participants expect the yuan’s weakness to persist for the time being, some expect the central bank to at least slow the pace of its decline.

“The PBOC can also prevent one-way speculation through macro-prudential tools, verbal guidance and unwinding the massive foreign exchange deposits accumulated by commercial banks over the past two years,” said Xing Bin, chief China economist. Morgan Stanley (New York Stock Exchange:).

So far, the only sign that the People’s Bank of China may be uneasy about the yuan’s recent devaluation came at the end of April, when it reduced the foreign exchange reserves banks had to hold.

The following are the policy moves and measures taken by the People’s Bank of China over the past few years to curb excessive RMB volatility:

** Countercyclical factor in fixed formula per yen

Back in 2017, the People’s Bank of China added a countercyclical factor to its formula for determining the daily midpoint of the yuan’s exchange rate against the U.S. dollar.

The central bank has never disclosed how it calculates the countercyclical factor, but regulators have described it as a way to better reflect fundamental supply and demand and mitigate the effects of herd mentality in money markets.

At the end of 2020, the renminbi strengthened due to higher foreign capital inflows and improving economic fundamentals, hence the suspension.

** Daily midpoint setting

Onshore spot renminbi can be traded within a 2% band around the midpoint of the daily fixing set by the People’s Bank of China.

Forex traders believe any major discrepancy between the market’s forecast of a possible fixed exchange rate and where the PBOC actually sets the midpoint is an indication of how the central bank wants to pull the market.

** Verbal information

Senior officials at the central bank and foreign exchange regulators use public speeches and comments in the state media to send messages to money markets, often reiterating their commitment to keeping the yuan largely stable.

In 2018, Pan Gongsheng, deputy governor of the People’s Bank of China, warned speculators against shorting the yuan, reminding them of the country’s healthy economic fundamentals and ample foreign exchange reserves.

** Higher derivatives transaction costs

In 2018, the People’s Bank of China raised the cost of shorting the yuan in the derivatives market for financial institutions by raising the foreign exchange risk reserve ratio from zero to 20%.

By the end of 2020, it dropped to zero again.

** Offshore RMB liquidity tightening

To reduce offshore renminbi liquidity, the People’s Bank of China issues renminbi-denominated bills in Hong Kong.

Although the amount was small, analysts said the move sent a clear message guiding yuan exchange rate expectations.

** National Bank Action

In the early stages of yuan weakness, China’s major state-owned banks were caught selling dollars, and while they had their own orders to execute, they were thought to be acting at the behest of the People’s Bank of China, bankers told Reuters.

The 2018-2019 period also saw state-owned banks convert the yuan into dollars and immediately sell them into the spot market to prop up the yuan.

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