Yuan Implied Volatility Spikes To 2-Year High As PBOC Widens Trading Bans (Slows Carry Trade)
While Goldman is quickly down-playing the decision by the PBOC to double the size of the daily trading bands for USDCNY to +/2.0% as a risk-off event (just as it was in 2012 - but blame that on Greece as cause rather than symptom), BofA is a little less sanguine about the move noting a more volatile CNY/USD without trend appreciation will deter hot money inflow and perhaps will result in some unwinding of previous inflow. With 1-month volatility spiking to over 4% (its highest in over 2 years), the move is sure to remove some carry traders as risk-rewards break down on their leveraged positions.
Implied volatility is dramatically higher (i.e. the market is pricing in expectations of more volatility going forward) which reduces the risk-reward characteristics of the carry trade and thus removes many players (or at best merely reduces their leverage)...
The PBoC widens CNY/USD daily trading band to +/-2.0%
The PBoC on 15 March announced to widen the yuan-dollar (CNY/USD) daily trading band to +/-2.0% from +/-1.0%, effective from 17 March. The previous band widened took effect on 16 April 2012 when the band was widened from +/-0.5% to +/-1.0%.
This should not be a big surprise to the markets as the PBoC has made it clear recently that it would widen the band this year. Perhaps the timing of this band widening is slightly ahead of what markets had expected.
What's the most important message?
The band widening strengthens the PBoC's signal that the one-way bet on CNY gain is over, and we should expect more CNY/USD volatility going forward. In the PBOC's own words, two-way yuan fluctuation will become the norm. In the past month we have observed falling interbank rates and falling CNY/USD in China. We believe these moves were engineered and coordinated by the PBoC to solve the dilemma (rising rates, rising hot money inflow and rising CNY) it was facing in 2013.
Where can the CNY/USD exchange rate go?
Chinese policymakers and academia have reached the consensus that the current USD/CNY (spot rate was 6.15 as of 14 March) is very close to its equilibrium level, so perhaps we will see neither trend appreciation nor trend depreciation in the near term. In the medium to long term, the equilibrium value of CNY/USD will be determined by a number of factors including money supply and inflation in China and the US.
What's next step regarding China's FX regime reform?
We believe the PBoC won't stop here, but further band widening is of little meaning. A much more important and meaningful reform is to change the mechanism on setting the daily fixing of CNY/USD. In our view, China will eventually shift to a market-based FX regime. As an intermediate step, China could peg yuan to a basket of currencies weighted by the importance of its trading partners. More specifically, the Singapore's BBC (Basket, Band and Crawl) regime seems to be favored. A reform towards a real managed float such as the "BBC" system requires a group of more confident and pragmatic political leaders who are true believers of markets. We think the time is ripe as the current leaders, who consolidated their power base at a much faster pace than expected in 2013, are market oriented.
What's the impact on capital flow and growth? What's the impact on money flow and the economy?
In our view, a more volatile CNY/USD without trend appreciation will deter hot money inflow and perhaps will result in some unwinding of previous inflow. However, it should not be a big worry as China's has a massive US$4.0tn FX reserves, 20% reserve requirement ratio (RRR) and only 67% loan-to-deposit ratio. If capital outflow risks the stability of interbank liquidity and base money supply, the PBoC has a big room to inject liquidity by cutting RRR or purchasing government bonds. So the only thing we need here is a more flexible PBoC which closely monitors interbank liquidity and interbank rates. Chinese exporters will overall benefit from the band widening which sends strong signal of the end of one-way appreciation of CNY/USD. Note last year CNY appreciated around 6% against its basket, putting big pressure on Chinese exporters.
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