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The People's Bank of
China (PBoC) has announced that the allowable
daily volatility on non-USD yuan forex
transactions has been doubled, from 1.5% to 3%,
effective Friday, September 23. On one level, this
is a pragmatic adjustment to the regime that was
installed on July 21, which proved too
constraining. However, the move is not about
incremental change in favor of flexibility or
transparency. It is about enhancing the
workability of the intermediate style of currency
regime that China has saddled itself with since
July 21, when the yuan was revalued 2.1% against
the dollar. It is also a recognition that the
arithmetic of the trading bands originally
announced did not add up.
The currency
regime China instituted earlier this week had the
following basic characteristics. First, the US
dollar/Chinese yuan (USD/RMB) rate would be
allowed to fluctuate within a plus or
conminus 0.3% band on a daily
basis. The middle of the band would be set at the
announced closing rate from the prior day's
trading. Second, non-USD cross rates, mainly
Chinese yuan/Japanese yen (RMB/JPY) and euro/yuan
(EUR/RMB), would be allowed to move within plus or
minus 1.5%.
To the untrained eye, nothing
seems amiss with this system. However, eyebrows
were immediately raised in the engine rooms of
many regional central banks and monetary
authorities. To foreign exchange practitioners at
active central banks, it was immediately obvious
that these constraints had the potential to create
serious logistical issues for the PBoC's
intervention operations, possibly on a daily
basis.
Keeping the constraints the PBoC
has placed upon itself in mind, consider the
following scenario: suppose that on the same trade
day, EUR/USD moves 2% in the euro's favor, and
USD/JPY moves the same amount in the yen's favor.
In any such situation, the decline of the dollar
will tend to put downward pressure on the USD/RMB
rate as well. So the PBoC would, of necessity, buy
dollars to keep the yuan within the 0.3% band. But
by doing so, it would put itself in danger of
breaching the 1.5% volatility bands against the
euro and the yen. So it would also have to buy yen
against the yuan. And then it would need to trade
EUR/RMB - and find that there is no liquidity.
A notable feature of the turnover data on
CFETS (China's unified onshore foreign exchange
trading platform) is the lack of any interest in
euro transactions. Since the euro's inception in
1998, it has never constituted as much as 1% of
the turnover on CFETS. And is easy to see why. As
long as the Chinese yuan is fixed to the US
dollar, which is the benchmark currency for trade
invoicing, why would Chinese firms denominate
contracts in euros, needlessly opening themselves
up to foreign exchange risk? And as existing
foreign exchange regulations make the yuan
convertible only on the current account, it is
"real demand" for foreign exchange that logs the
vast majority of onshore deals.
Returning
to our hypothetical scenario, it is possible in
theory for the PBoC to sell euros and buy dollars
directly, but it is extremely unorthodox for a
central bank to conduct market operations in a
cross not including its own currency. Further, the
degree of intervention required to affect the
overall trend in EUR/USD could be massive. And
what about the signaling effect on traders if they
see the PBoC in this market? What motives will
they assume? Are there any implications for
reserve diversification? If we had chosen the
opposite scenario (EUR and JPY falling 2% against
the USD), in which the PBoC might be seen buying
euros, this would fuel a major intra-day sentiment
swing in EUR/USD, if a major diversification of
China's US$741bn in foreign exchange reserves was
rumored.
Hopefully this mental exercise
makes it clear that the arithmetic of the regime
established on July 21 was incompatible with
volatility in the G3 currencies (USD, JPY, and
EUR). The new barriers, established last Friday,
offer less potential for the non-USD crosses to
add to intervention requirements on a daily basis.
It should be absolutely clear, then, that the
recent adjustment is about the mechanics of the
previous regime. It is not about accommodating
greater flexibility in the exchange rate; rather,
it is about the PBoC's credibility as a monetary
manager.
The previous strictures put the
bank in the precarious position of maintaining a
regime that they may not have had the means to
administer efficiently. That has been alleviated
to some extent, but can never be fully
accomplished under the intermediate regime that
China has stumbled into. Indeed, it is surprising
that China has willingly made the width of the
non-USD trading bands public. Transparency in
these matters assists market players to speculate
more scientifically than would otherwise be
possible. This is certainly not the goal that the
PBoC - which has shown by countless statements
that it regards speculators as the enemy - had in
mind.
This is truly forex policymaking on
the run.
Huw McKay is a senior
international economist at Westpac Bank in Sydney,
Australia. He is the bank's spokesperson on
pan-Asian economic and market issues.
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
contributing.
