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Getting Burned in China’s Currency Markets
Predictability is the curse of central banking when it gives speculators a sure thing. Every day for the past several years, investors have been visiting their banks in Hong Kong to convert Hong Kong dollars – pegged to the US dollar – into a maximum of RMB20,000 per day on the supposition that the renminbi would continue rising in value against the US dollar forever.
Chinese companies borrowed US dollars and faked invoices to repatriate funds for investment at high yields in the shadow banking market, distorting China’s trade figures and frustrating the People’s Bank of China’s efforts to tighten monetary policy. The renminbi carry trade has worked like a charm. Since 2005 the currency floated up against the US dollar from about RMB8.25 to 6.15 today, a gain of about 25 percent.
That was then. China’s central bank now aims for constructive ambiguity, following the classic dictum Tao Guang Yang Hui, literally translated as "Hide the light and feed the darkness". That is an all-time favorite tactic, especially in times of uncertainty.
The key takeaways from Saturday's announcement by the People’s Bank of China to widen the yuan-dollar trading band starting March 17 can be found in the beginning and end of the PBOC's prepared Q&A statement:
Why do it? Short-term, the prospect of a two-way bet on CNY discourages hot money flows. But the wider currency band also points towards deeper reforms. Beijing promised that the market would be taking a more decisive role in the allocation of resources in the Third Plenum last October. A flexible foreign exchange rate is key for faster reform. That means that rather than consistently guiding the currency up, as the China Foreign Exchange Trade System has done for the past nine years, it can now go down. And indeed it has, tumbling 1.6 percent against the US dollar.
What’s next? The PBOC will quit daily intervention in the FX market unless irregularities strike.
The central bank’s most recent intervention came in late February, when the currency slumped sharply, falling by 0.45 percent, short-circuiting what is called the carry trade. Chinese companies had been using various subterfuges to borrow US dollars at low interest rates, then bring them into China to lend in the shadow banking market at far higher rates. That included the use of industrial metals like copper and iron ore as carry-trade collateral.
As REORIENT Group’s David Goldman wrote last week, “In the context of the PBOC’s cleanup of hot money flows, Chinese banks cut off credit to importers who had used metals as a vehicle for the carry trade, eliminating a short-term source of demand for iron ore and copper. The cutoff of financing pushed copper into free fall on March 7, a day when there was no economic or other relevant news in the market. From the Chinese vantage point, a fall in metals price was beneficial, if anything. China is the world’s biggest net importer of metals and falling prices cheap its costs. As prices fell, the commodity financing desks of international banks tightened credit lines to major trading companies, forcing them to reduce positions quickly, and the copper price continued to plunge, to just 300.55 at today’s close from 347 last Dec. 27 and 330 on February 21.”
Now, beginning March 17, interbank USD/CNY quotations can deviate from the published central parity rate by plus or minus 2 percent, compared to the previous band of plus or minus 1 percent. Designated foreign exchange banks can offer clients US dollar buying and selling rates at 3 percent away from the central parity midpoint, up from 2 percent. The news was welcomed by foreign exchange salesmen everywhere.
The decision to give the market more leeway in setting a key economic input shows that Beijing is not about to go back on its promise to usher in changes, even if they cause occasional pain. Premier Li Keqiang sees comprehensive reform as the only way out for slowing foreign trade, concerned consumers and slower industrial output while insisting on a prudent (slightly tighter) monetary policy.
Financially, the slightly wider trading band is a limited experiment in the opening of China’s monetary system. It is a low risk step that could offer the Chinese regulators a great amount of information for further liberalization of the country’s capital accounts. A country’s exchange rate provides key signals about monetary policy: all else being equal, a depreciating currency signals that monetary policy is lax and an appreciating currency signals that monetary policy is tight. A central bank has a variety of tools to manage monetary policy, including open market operations, reserve requirements and other regulatory measures. China needs to learn how to manage a major currency in an increasingly free market, and the wider band will give the PBOC the opportunity to test its controls.
More meaningfully, a wider trading band also signifies that the PBOC is gaining monetary policy independence as it moves towards a managed floating currency framework similar to Singapore’s. The renminbi'’s long-serving tie to the USD has offered great stability for Chinese businesses involved in international trade, but the dollar peg has a downside: It forced the PBOC to follow the Federal Reserve’s highly expansive monetary policy, eliciting huge capital inflows. To manage China’s economic restructuring, the PBOC must assert control of its own monetary policy.
How the daily midpoint fixings of the renminbi to the US dollar are determined going forward will be a key question. The Monetary Authority of Singapore “manages the Singapore dollar against a trade-weighted basket of currencies of Singapore’s major trading partners and competitors, and maintains it broadly within an undisclosed target band.” Logically, the PBOC will want to do the same for the renminbi and use the wider trading band to its advantage. The central bank’s goal is the same as those of the MAS, which is to achieve price stability for sustainable economic growth.
The PBOC believes that the renminbi is trading at fair value and does not expect major depreciation or appreciation. Short-term market bearishness towards China and a slightly softer currency offers modest benefits to exporters, just as the crackdown on the misuse of metals inventories to finance the carry trade had the ancillary benefit of reducing import prices.
China’s economic planners are adept enough not to get on the bandwagon for stimulus. Premier Li stated clearly that a GDP target "around 7.5 percent" was adequate at last week’s dual meetings of the National People’s Congress and the Chinese People’s Political Consultative Congress means he can accept GDP below or above the number so long as an adequate number of jobs are being created.
Beijing's de-emphasis on GDP has not yet given economists a free pass on their forecasts. Judging from the modestly softer growth rates in key economic indicators so far, the first-quarter GDP forecast is will probably come in between 7.3 to 7.5 percent, easing from 7.7 percent in the previous quarter. Nevertheless, the fruits of reform are what to look for this year, hence full-year 7.7 percent growth is still anything but impossible.
Steve Wang is Chief China Economist and Head of China Research for the Hong Kong-based REORIENT Group. He is a regular contributor to Asia Sentinel