Is The Yuan About To Tumble After Friday's Shocking PBOC News? Here Is Goldman's Take

In a move that stunned China currency watchers, late on Friday (local time) Bloomberg reported that China’s central bank decided that it would remove a reserve requirement for financial institutions trading in FX forwards for clients by cutting it to zero from 20% currently. The change would take place on Monday, September 11 (it has yet to be confirmed). As a reminder, banks, funds and other financial institutions trading FX forwards for clients were required from October 2015 to set aside 20% of the past months’ sales as reserves in a move that was aimed at curbing currency speculation. Subsequently, the PBOC further punished traders, or rather shorts, by boosting short-term margin requirements on FX positions, making it virtually impossible to hold on to a short position for a long period of time.

All that changed at the end of last week, when the PBOC effectively "U-turned", and gave a green light to the same FX speculators whom it criticized (remember the Chinese anti-Soros media campaign), slammed, punished, and in some cases arrested, to now short the Yuan once more.

The reason behind the move was simple: in recent weeks the Yuan, both on and offshore, had soared far too high, to the point where Beijing was getting worried about its impact on exporters, as a separate Friday report from Reuters discussed.

On the surface, this was a brilliant solution to Beijing's problems: it lowers the Yuan on one hand, and on the other, it is not the PBOC who is manipulating the currency, it's the evil speculators who are "guilty", avoiding being blamed by the US for currency manipulation. Most importantly, the removal of this marginal capital control worked immediately, as the following intraday chart of Friday's USDCNH clearly showed.  

So will this plan work, and is the Yuan set to plunge in Monday trading? We will find out soon enough, but until then, here is the explanation from Goldman's MK Tang on what Friday's move means, and its implications for Yuan policy, but first, here are several analyst opinions, as summarized courtesy of Bloomberg:

CIB Research (Guo Jiayi, Zhang Meng, analysts)

  • Scrapping the reserve requirement indicates the PBOC is confident of the yuan’s outlook
  • Given the weakening dollar and solid domestic economic environment, it’s unlikely the new rules will bring one-way expectations to exchange rates
  • Indicates the PBOC wants to slow yuan appreciation and prevent a herd effect, and it opens the window for further FX regime reforms

Commerzbank (Zhou Hao, emerging-markets economist)

  • Policy change underscores that depreciation pressure has largely diminished
  • PBOC signals it’s again sitting opposite the market as fresh long CNY positions triggered a rapid appreciation over the past week
  • Spread between CNY and CNH forwards to narrow significantly in coming months

Lianxun Securities (Li Qilin, macro researcher)

  • PBOC wants to ease strong appreciation trend, which could affect exports
  • Chance is limited for the yuan to continue the fast pace of strengthening of the past couple of weeks
  • PBOC is likely to show a stronger hand if markets don’t take note

Mizuho Bank (Ken Cheung, strategist)

  • Good time to spur hedging demand in both directions in the forwards market
  • Institutions which invest in onshore bonds via the Bond Connect can thus hedge FX risks onshore
  • Expects USD/CNH one-year forwards to drop, leading to narrower spread between onshore and offshore

ANZ (David Qu, markets economist)

  • Change won’t significantly cut corporate FX settlements, which are largely decided by spot prices
  • Demand from companies to buy dollar is rather tepid, so any future increase in forward positions should be limited
  • New rule will have limited impact on spot market, where central bank “guidance” will play a bigger role
  • It’s likely prohibition on net outflows in cross-border RMB pooling will be relaxed or canceled amid yuan strength

Finally, here is Goldman's extended take:

Reported relaxation of FX hedging cost: backdrop and implications for CNY policy

Chinese media reported late last Friday (though not officially confirmed) that effective Sep 11, the PBOC would cut the reserve requirement on FX derivatives sales to 0% (from 20%), which would reduce the cost of FX hedging by importers.

We see three implications:

  1. the authorities may be less concerned about outflow pressures, which appear to have dissipated following earlier episodes of likely intervention-driven CNY strength to counteract bearish sentiment;
  2. it marks a possible meaningful step preparing for increased (two-way) CNY volatility in the medium term; and
  3. shows the continued importance of tracking signals of policy intention (including the fixing’s “countercyclical factor”) on the near-term CNY path, which seem to point to reduced comfort with the ongoing pace of appreciation.

Main points:

We provide an overview of the FX reserve requirement, and discuss the backdrop for the reported relaxation and the likely implications for the CNY policy.

1. What is the reserve requirement (RR) on FX derivative sales?

Introduced in Sep 2015, the RR sets the amount of FX that each bank has to deposit at the PBOC (with no interest remuneration) in connection with its sales of FX derivatives (including forwards, swaps, etc.) to non-bank customers. The RR has been set at 20% of the notional value of the derivatives.

This is effectively a tariff, increasing the cost for non-bank customers to buy FX via derivatives. Its introduction was in response to strong outflow pressures at that time, part of which was driven by a large amount of FX forwards bought by non-bank customers (worth close to $80bn in August ’15, c. 3x the previous usual amount). The authorities attributed the sizable demand for FX forwards to unhealthy speculation. FX forward purchases have sharply fallen since the RR measure, to less than $20bn in Sep ’15 and less than $10bn in recent months.

Late last Friday (Sep 8), Chinese media (e.g., 21st Century Business Herald) reported that the PBOC would lower the RR to 0% effective Sep 11, although at the time of writing this has not been officially confirmed.

2. What is the recent backdrop for the reported relaxation?

Outflow has significantly slowed since the turn of the year, likely reflecting tighter capital control as well as reduced devaluation concerns. That said, in the first several months of the year, market pressures were still skewed toward net CNY sales. In this context, in May the authorities added a "countercyclical factor" to the CNY fixing mechanism, initially intended to counteract the market’s "herding" behavior that had pressured the currency weaker.

Under the new fixing rule, when the market displayed a CNY-bearish tilt (CNY close weaker than fixing), the countercyclical factor the next day would tend to push CNY fixing stronger, as we have discussed here. But such fixing guidance alone did not seem to be effective. Instead, in late May through early August, we have observed three episodes of sharp appreciation, perhaps driven by policy intervention to entrench the countercyclical factor’s credibility and negate bearish CNY sentiment.

However, more recently since mid-August, the flow pressure seems to have reversed and the CNY strength more market-driven. The August reserve reading, which implies net FX purchase by the PBOC to lean against CNY appreciation, is the first official data suggesting this shift, although we await further flow data for confirmation. The reversal of market forces likely reflects the success of the earlier episodic policy support of the CNY in changing market psychology, as well as a weak USD and better China sentiment.

3. What are the implications for the CNY policy?

The reduction of the reserve requirement on FX forwards to zero would mechanically lower the cost of outflows via derivative transactions. In terms of policy, we see the following three implications:

  • The authorities have become a bit less concerned about outflow pressures. Therefore, the RR relaxation could be a precursor for incremental unwinding of other capital control measures, should the flow situation remain benign.
  • A meaningful possible step preparing for increased (two-way) volatility in the CNY in the medium term. Besides reflecting higher policy tolerance for outflows, the RR relaxation has the clear effect of lowering the cost for importers to hedge their FX liability exposures. Such hedging would in turn mitigate a main negative side-effect of having a more flexible FX regime, which has long been one of the authorities’ structural policy objectives.
  • As for the near-term CNY outlook, while assessing market pressures helps, interpreting policy intention is probably even more important. For instance, reserve data suggests the PBOC bought about $10bn in FX in August, only a moderate amount by China's historical standards; it could conceivably have bought materially more to limit the CNY appreciation.[1] The fact that it didn't seems to indicate that the authorities were comfortable with, or even desired, the strong CNY in August.
  • There could be “too much of a good thing” more recently, though. We maintain our view that risk of major depreciation is limited in the run-up to the Party Congress (to start on Oct 18). That said, we believe it is useful to continue tracking policy signals for the near-term CNY intention, including the countercyclical factor. Just when bullish changes in the countercyclical factor (i.e., $/CNY fixing below CFETS model-implied) preceded policy efforts to push the currency stronger in May-July, a bearish change in this factor currently could signal a decreased policy comfort with the continued CNY appreciation. On this score, we note that the countercyclical factor in the last few days has turned more reactive to the market appreciation pressures (Exhibit 1), potentially pointing to lower propensity to accommodate much further CNY strength.

Exhibit 1: Countercyclical factor has become more reactive to the previous day’s appreciation, hinting at decreased policy comfort with further CNY strength