On Friday, May 26, the People’s Bank of China announced it would overlay a “counter-cyclical factor” onto the existing model for calculating the daily central parity rate of the Chinese Renminbi. In other words, it would, when it deemed appropriate, aggressively guide the currency fixing against the markets.
That announcement, along with a tightening in both onshore and offshore RMB interest rates, has helped squeeze some speculative short positions in the currency, and strengthen the RMB.
*** The introduction of a “counter-cyclical” overlay when needed onto the FX mechanism is not just a response to near term pressure on the currency. It was also put in to pre-empt what Beijing expects will be continued depreciation pressure on the RMB from tightening monetary policy in the US. Those include expectations in Beijing for a June interest rate hike by the Federal Reserve, as well as expectations that the Fed will start reducing its balance sheet this year, and possibly hike rates again in December. ***
*** To keep currency pressures under control, Premier Li Keqiang and Vice Premier Ma Kai have also given a nod to the PBoC to hike Chinese interbank rates by 10 basis points in parallel with a 25 basis points hike by the Fed on June 14. A modest, 10 basis points hike in interbank rates will be presented as a reflection of improving global and domestic economies, and not a signal of any major shift in domestic monetary policy. The PBoC will characterize its monetary policy as neutral, with “prudential considerations conducive to stabilizing the entire financial system,” pursuing the goals of moderate liquidity, reasonable growth of credit and financing, modest interest rates, and stable FX rates. ***
*** The Central Financial Leading Group (CFLG), led by Li Keqiang and Ma Kai, are also planning from what we understand to enhance the PBoC’s powers by folding the China Banking Regulatory Commission (CBRC) into the central bank. The leadership in Beijing will seek to transform the PBOC, as the central bank of the second largest economy, into a more authoritative and independent institution by next year’s State Council meeting, scheduled to be held in March of 2018. ***
*** We believe Beijing will appoint Guo Shuqing, the current Chairman of the CBRC, to replace the veteran PBoC Governor Zhou Xiaochaun as head of the merged entities. Among his achievements, Guo has gained recognition for measures he has taken as head of the CBRC to stop lending to zombie and shell companies, setting out guidelines highlighting the 10 main types of risks that are to be avoided. The hope is that under his guidance and reforms, China’s all-important ratio of non-performing loans (NPLs) to GDP will continue to decline from last year. ***
*** China’s two other major financial regulatory institutions, the CSRC (China Securities Regulatory Commission) and the CIRC (China Insurance Regulatory Commission), will remain independent. But on the equity and securities side, the State Council has tasked the CSRC to roll out a major new set of regulatory measures before the end of this August to guide stock investing, expected to be drawn from the generally accepted practices of developed economies. ***
Officials hope these revisions will usher in a new investment environment, come September, of investors more focused on long-term value investment than on short-term speculation. The hope, at least, is these CSRC reforms will also provide a positive boost to China’s equity markets for the last four months of the year.
Back to the Future – Managing FX Rates
The decision to give additional powers to the People’s Bank of China to manage FX rates is an implicit acknowledgement that recent measures to make China’s currency more market driven have not been working as desired, despite assertions to the contrary.
It is an acknowledgment by China’s leadership of the necessity to (re-) emphasize RMB stability, rather than flexibility, a flexibility which as it stands to them has only seemed to lead to constant outflows and weakening pressures.
Officials observed that since the introduction of the enhanced RMB central parity quotation mechanism by the PBOC on August 11, 2015, the RMB has been far too easily driven by “irrational market expectations” in forex markets, especially expectations of unilateral depreciation of the RMB against the dollar. This has led to a RMB exchange rate against the dollar that has been overly volatile, and not always a reflection of what they believe to be China’s true economic fundamental or financial situation.
And so, after more than 20 months of operating under this mechanism, PBOC Governor Zhou Xiaochuan requested a meeting on May 12 with Premier Li and Vice Premier Ma.
At that 45-minute meeting in Li’s office, the leaders agreed the goal of having a more market based central parity to serve as the benchmark for market exchange rates was no longer suitable for China.
They agreed the introduction of a counter cyclical factor to the existing mechanism would “allow” markets to better reflect the fundamentals of China’s economy, as well as supply and demand factors in the FX markets, and at the same time, strengthen the central bank’s guidance role in setting rates for the markets.
While they still maintain the PBoC must do its best to let the RMB take center stage in the global currency markets, the leadership believes the central bank must also now play the largest role in the process of internationalization of the RMB.
Anticipating continued pressure and volatility around the currency as the Fed normalizes rates, officials believe Zhou has done well to introduce this counter cyclical factor now, allowing the central bank to openly respond and intervene in case of unexpected fluctuations, whether excessive appreciation or depreciation, mainly against the dollar.
The fact that ratings agency Moody’s happened to downgrade China’s credit ratings right as the PBOC rolled out these measures, and that the PBoC for all these developments and pressures has successfully kept the USD/RMB from breaking above the 6.9000 level, is only seen as a case in point.