What is the PBOC re­ally up to?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

The Peo­ple’s Bank of China sprang a sur­prise on Tues­day morn­ing, lift­ing the daily fix­ing rate for the US$-CNY ex­change rate by 1.9% and trig­ger­ing an ef­fec­tive 1.8% de­val­u­a­tion of the ren­minbi—the cur­rency’s big­gest one day move since July 2005 when Bei­jing started its ex­change rate re­forms.

At first glance, the move looks like a re­sponse to months of dis­mal trade data. In our view, this ex­change rate move is a lot more than a panic re­ac­tion to de­te­ri­o­rat­ing ex­ports. It is part of a longer term re­form process aimed at par­tially lib­er­al­is­ing China’s ex­change rate pol­icy ahead of the ex­pected in­clu­sion of the ren­minbi in the In­ter­na­tional Mon­e­tary Fund’s Spe­cial Draw­ing Rights bas­ket. Suc­cess­fully im­ple­ment­ing this pol­icy over the com­ing days and months, how­ever, will con­front the PBOC with some tricky chal­lenges.

The cen­tral bank ex­plained its move by say­ing it was aimed at “im­prov­ing the quot­ing mech­a­nism of the US$CNY fix­ing price”. In re­cent months the PBOC has kept its daily fix­ing rate steady, ef­fec­tively peg­ging the ren­minbi to the US dol­lar. Mean­while, the spot ex­change rate has re­mained glued to the weak side of the ren­minbi’s per­mit­ted trad­ing band (the fix­ing rate plus or mi­nus 2%), re­flect­ing mar­ket be­liefs that by link­ing the ren­minbi to the strong US dol­lar, Bei­jing was al­low­ing the Chi­nese cur­rency to be­come in­creas­ingly over-val­ued.

But while main­tain­ing ex­change rate sta­bil­ity against the US dol­lar served Bei­jing’s short term ends—no­tably by help­ing Chi­nese com­pa­nies which have ac­cu­mu­lated siz­able US dol­lar li­a­bil­i­ties—it con­flicted with the cen­tral bank’s longer term ob­jec­tives. That is partly be­cause the PBOC wants to re­duce its daily in­volve­ment in the mar­ket, but also be­cause SDR in­clu­sion will nec­es­sar­ily re­quire greater ren­minbi ex­change rate volatil­ity.

This last point may sound counter-in­tu­itive, but ac­tu­ally makes good sense. Bei­jing be­lieves SDR in­clu­sion to be cen­tral to pro­mot­ing the ren­minbi as a suc­cess­ful in­ter­na­tional re­serve cur­rency. How­ever, if the PBOC were to con­tinue to keep the ren­minbi sta­ble against the US dol­lar, the ef­fect of in­clud­ing it in the SDR would sim­ply be to in­crease the weight­ing of the US dol­lar in the bas­ket—the op­po­site of what the IMF wants to achieve. As a re­sult, to jus­tify its in­clu­sion in the SDR, the ren­minbi must show greater volatil­ity against the US dol­lar.

The PBOC ap­peared to take an im­por­tant step in this di­rec­tion, when it an­nounced that it would re­form the daily fix­ing mech­a­nism to let the mar­ket play a more im­por­tant role in de­ter­min­ing the price. Un­der the new mech­a­nism, the PBOC will ask mar­ket­mak­ers—mostly Chi­nese banks—to sub­mit rates for the daily fix­ing with ref­er­ence to the pre­vi­ous day’s clos­ing spot rate. In the­ory, this would in­deed al­low a greater role for the mar­ket in de­ter­min­ing the ren­minbi’s ex­change rate and for greater volatil­ity. In prac­tice, im­ple­men­ta­tion will present some chal­lenges.

1. If the PBOC were re­ally to let the mar­ket set the fix­ing rate, to­mor­row’s fix would move into line with to­day’s spot rate, which would mean another 1.5%-2% de­val­u­a­tion. Sim­i­lar moves would fol­low on sub­se­quent days as the mar­ket tested the cen­tral bank’s will, with the ren­minbi’s ex­change rate very likely over­shoot­ing to the down­side in what would amount to a sig­nif­i­cant de­val­u­a­tion.

2. If the PBOC it­self de­ter­mines the fix­ing rate to­mor­row (and on sub­se­quent days) in or­der to calm the mar­ket, the fix­ing mech­a­nism will have not changed, and the cen­tral bank will have achieved noth­ing by Tues­day’s move.

In re­al­ity, the PBOC is likely to at­tempt to steer a mid­dle course, dic­tat­ing the fix­ing rate to­mor­row and on sub­se­quent days to calm mar­ket jit­ters, but grad­u­ally al­low­ing the mar­ket to play a greater role in de­ter­min­ing the daily fix, in or­der to al­low greater day-to-day volatil­ity in line with its longer term aims.

Get­ting things right—step­ping back from the mar­ket while con­tin­u­ing to di­rect the long term tra­jec­tory of the ren­minbi’s ex­change rate—will be tricky, and the PBOC’s de­gree of suc­cess will only be­come ap­par­ent over the next month or two. But by mov­ing now to in­tro­duce more ex­change rate volatil­ity—months be­fore ei­ther we or the mar­ket ex­pected—the PBOC has shown a deft sense of tim­ing and an im­proved un­der­stand­ing of mar­ket psy­chol­ogy.

In the longer run, we ex­pect Tues­day’s move to her­ald not only greater day-to-day volatil­ity, but a greater tol­er­ance of ren­minbi weak­ness against the US dol­lar in a strong US dol­lar en­vi­ron­ment. While this move was not aimed di­rectly at en­hanc­ing China’s ex­port com­pet­i­tive­ness, the PBOC does have do­mes­tic as well as in­ter­na­tional goals in set­ting the ex­change rate.

With it now widely ac­knowl­edged af­ter a decade of sub­stan­tial ap­pre­ci­a­tion that the ren­minbi is no longer un­der­val­ued—and with SDR in­clu­sion prob­a­ble next year, mak­ing the pro­mo­tion of ren­minbi in­ter­na­tion­al­i­sa­tion less ur­gent—the in­ter­na­tional goals are fad­ing in im­por­tance. Mean­while, weaker do­mes­tic de­mand and poor ex­port growth give the PBOC more rea­son to fo­cus on its do­mes­tic goals. That does not mean China will in­dulge in com­pet­i­tive de­val­u­a­tion. But it does mean that in a strong US dol­lar en­vi­ron­ment the author­i­ties will be more in­clined to tol­er­ate a de­gree of ren­minbi weak­ness against the US dol­lar in or­der to main­tain ex­change rate sta­bil­ity against a bas­ket of cur­ren­cies.

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