a swift update on RMB exchange controls
Hey Beijing watchers!
Well…what a difference a weekend makes. Are we now experiencing the 'two unprecendenteds'? The media so often dub Xi’s third term 'unprecedented'. Well, the weekend was yet another 'unprecedented' for the PRC… Bill Bishop has a pretty sober take on what might happen next on his Sinocism chat.
Meanwhile, this week, we look at the macro economy. Fallout from the downturn has been the continuing decline of the RMB. It had a very minor rally at the end of last week but is on its way back down. In this update, we look at the tools Beijing has to control the currency.
I trust this helps you follow the downs and the hoped-for ups of the exchange rate.
The RMB has depreciated steadily since April 2022. A mix of concerns over the domestic economy and the US Federal Reserve interest rate hikes have derailed PBoC moves to support the economy. Reluctant to let the currency move one way for too long, allowing investors to build up substantial short positions, the PBoC (People’s Bank of China) intervened in late summer and early autumn.
The PBoC uses a managed-float currency regime. It sets a daily central parity rate for the onshore RMB (CNY), i.e., currency traded in the PRC. The exchange rate is allowed to fluctuate within two percent above or below the parity rate. If trading sees it overshoot two percent, the bank steps in—most often through conventional steps of buying and selling. The offshore RMB (CNH) is allowed to trade outside the PRC in cities like Hong Kong and Singapore; their CNH markets are less controlled than the onshore RMB.
In addition to typical central bank tools—buying and selling foreign exchange and adjusting interest rates—the PBoC uses several others to stop the RMB from either appreciating or depreciating.
foreign exchange deposit reserve ratios
The foreign exchange deposit reserve ratio controls how much forex deposits banks are required to hold in reserve with the PBoC (the central bank). Lowering the ratio allows more foreign currency into the market (boosting dollar liquidity and creating more demand for the domestic currency), putting appreciatory pressure on the RMB.
The ratio was lowered from 8 to 6 percent in mid-September 2022 to stem rapid RMB depreciation. The cut followed a previous decrease of one percent in May 2022. It was increased by two percentage points in June and December 2021 amid RMB appreciation and strong export growth. Previously, it underwent three upward adjustments in 2005-07.
foreign exchange risk reserves ratio
The foreign exchange risk reserves ratio for forward foreign exchange sales rose from 0 to 20 percent in late September 2022, as the RMB breached a critical threshold of 7:1 against the USD in mid-September. The rise will drive up net costs of forward settling of foreign exchange transactions, curbing the demand for forex and propping up the RMB.
A higher forex risk reserves ratio raises the cost for firms betting against the RMB and discourages shorting it. Having raised the ratio in 2015 and August 2018 to ward off depreciation, the PBoC lowered it in September 2017 and October 2020, when the RMB appreciated.
overseas lending parameters
To streamline and reduce overseas financing costs for domestic firms and finance institutions, macro-prudential management mechanisms for corporate and financial cross-border financing were introduced in 2016. A higher macro-prudential adjustment parameter means firms have a higher upper limit in borrowing from overseas funds, while a lower parameter does the opposite. The tool has been used to adjust domestic dollar liquidity and demand for RMB. The bank can adjust the parameters for either firms or banks or both.
The parameter was most recently increased from 1 to 1.25 on 25 Oct 2022 to encourage more overseas financing and capital inflow; it boosted the domestic dollar supply and reduced downward pressure on the RMB. The adjustment expands the scale of cross-border corporate financing by 25 percent and expands the space for SMEs to use foreign debt financing amid exchange rate fluctuations.
To slow RMB appreciation, the PBoC lowered the macro-prudential adjustment parameters for finance institutions (December 2020) and firms (January 2021) from 1.25 to 1. The parameter was raised from 1 to 1.25 in March 2020 in response to RMB depreciation at the peak of the pandemic.
countercyclical adjustment factors
The countercyclical adjustment factor was first introduced in the RMB/USD exchange rate central parity quotation model in 2017 to hedge against cyclical RMB depreciation and reduce forex volatility. The factor aims to add uncertainty to exchange rate pricing and prevent one-way market betting; it does not aim to change the RMB’s direction. The central parity rate is calculated based on ‘daily closing price+changes in a basket of exchange rates+countercyclical factors’. How this factor is determined is yet to be clarified by the bank, increasing the opaqueness of RMB pricing.
The factor was phased out in October 2020 during a bullish run by the RMB, supported, post-lockdown, by solid export growth from May 2020 that beefed up the RMB exchange rate some 7 percent. This was interpreted as a central bank pushing for a more market-based exchange rate. According to the Foreign Exchange Trading Centre, the factor remains a critical adjustment tool available for future use.
The RMB continues to depreciate against the USD after going above 7 in mid-September 2022, reaching 7.3 in late October. The PBoC, some suggest, has tacitly brought back the countercyclical factor to stabilise the RMB. Zhang Ming 张明, China Academy of Social Sciences Finance Research Institute deputy director, points out that the RMB/USD daily midpoint fixing rates stayed above market expectations within 1-3 days following each of the four US interest rate hikes this year: March, May, June and July.
Capital controls can be tightened to prevent capital outflows from increasing. Capital account liberalisation and RMB exchange rate market reform were deferred during the 2015-16 RMB depreciation and capital exodus; the PBoC then stabilised the exchange rate via large-scale sales of foreign reserves and tighter capital controls. Economists advised that the PRC’s highly leveraged financial system was unprepared for external shocks under an open capital account.
Capital account liberalisation resumed in 2020’s post-pandemic recovery. Foreign finance institutions were allowed to take majority stakes in their joint venture securities firms in China from April 2020. In September, foreign institutional investors gained greater access to the PRC market by combining two major inbound investment schemes—QFII (Qualified Foreign Institutional Investors) and RQFII (RMB Qualified Foreign Institutional Investors).
The Hong Kong/Macau-Mainland Wealth Management Connect was launched in September 2021 to open up the domestic financial markets further and ease cross-border portfolio investment flows.
Most of these moves encourage greater capital inflow rather than outflow; memories of the late 1990s Asian Financial Crisis are still front of mind for policymakers.
Hong Kong bills for offshore RMB
To control the offshore RMB exchange rate, the PBoC can dry up liquidity in the offshore RMB market by issuing yuan-denominated bills in Hong Kong, raising the HIBOR (Hong Kong Interbank Offered Rate), and increasing the cost of betting against the RMB, to stabilise the exchange rate.
The PBoC first used the mechanism in November 2018 to issue C¥20 bn central bank bills via the Hong Kong Monetary Authority Central Moneymarkets Unit (CMU). The offshore RMB/USD exchange rate rose by over 100 basis points on 7 Nov 2018 in response to the bill issuance. The bills are primarily short-term, with repayment periods of three months, six months and one year. The PBoC has issued such bills on nine occasions in 2022, most recently a batch of six-month C¥5 bn bills rolled out on 20 September.
more uncertainty coming
In addition to holding some of the world’s largest forex reserves, in combination with the above policy tools, state-owned banks can be directed to intervene to help increase or decrease demand for the RMB. But specifics on such informal guidance are lacking. With uncertainty driving up the US dollar, betting against the RMB must be ever more tempting. The PBoC will need all the tools at its disposal.