By Ye Xie, Bloomberg Markets Live commentator and analyst
The PBOC has sent the strongest signal yet that its tolerance for currency appreciation has run out. By raising the FX reserve ratio for a second time this year, it may temporarily halt the yuan’s rise. But it did not address the drivers of the rally that sent the trade-weighted yuan to the strongest since 2015: the massive dollars inflows from exporters and portfolio investments. To keep the exchange rate in check, it needs to open up channels to allow money to leak out.
The PBOC announced Thursday night that banks will need to hold 9% of their foreign currencies in reserve starting Dec. 15, from the current 7%. The reserve-ratio hike effectively drains the supply of dollars onshore, thus supporting the greenback against the yuan. It’s the second increase this year, following a similar move in June, which was the first hike since 2007.
The move prompted the offshore yuan to decline 0.5%, the most since July. While the mechanical impact of the move itself is moderate, the signal is unequivocal that PBOC is getting uneasy about the currency rally. The central bank has repeatedly warned about FX volatility and consistently fixed the currency weaker than analysts expected in recent weeks. It’s probably not a coincidence, then, that both hikes came when the yuan.
But Thursday’s move alone is unlikely to hold back the yuan for long. What’s behind the rally was the influx of dollars from exports and investment inflows. Neither forces are likely to reverse soon. The pandemic has bolstered China’s status as the factory of the world, while cutting off overseas traveling, a main channel for capital outflows. The inflows to its bond market are structural in nature as sovereign wealth funds, central banks and index followers just start to add Chinese assets into their portfolio.
Keep in mind that these dollar inflows haven’t been fully converted to yuan. It’s a source of dry powder that could push the currency stronger if China Inc. decides to exchange their dollar holdings for yuan. Foreign-currency deposits at banks have surged 15% this year to a record $1 trillion, more than the FX loans they can dole out.
Banks have been so desperate to find homes for these “excess” dollars that they tapped the once little-used foreign-currency reverse repo market (which is effectively collateralized dollar lending), which surged to a record $93 billion. They’ve also actively used the swap market to lend these surplus dollars out, driving swap points higher.
The PBOC still has many tools at its disposal to prevent a currency overshoot that would hurt Chinese exporters’ competitiveness. Goldman Sachs’ economists including Maggie Wei list a few:
- More verbal warnings against one-way bets
- Officially adding back the countercyclical factors to its yuan fixing, essentially setting the yuan weaker than otherwise
- Accumulate dollar reserves and/or ask state banks and experts to hold dollars
- Liberalizing FX outflows and tightening the channels for inflows.
Among these tools, the most effective would be allowing more outbound investments to offset the inflows. The authorities have already done some of that, including the launch of the Southbound bond connect that allows local residents to buy overseas bonds in Hong Kong.
More is probably needed.