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Bargaining chip for SDR inclusion
On the 11th of August, the PBoC surprised the currency markets by announcing a far higher fixing rate of 6.2298 vs. the previous rate of 6.1162 (10 August). This amounts to a 1.9% depreciation in terms of the daily fixing. Following this, the PBoC announced that the new central parity of CNY exchange rate against US dollar (‘USD’) fixing methodology will be based on actual spot USD/CNY close on the prior day with contributions by a panel of banks and some adjustment for overnight Move in major partner currencies. On the 12th and 13th of August, the PBoC affirms their commitment to the new pricing mechanism by fixing the central parity of CNY exchange rate against US dollar at 6.3306 (vs. previous close of 6.3250) and 6.40100 (vs. previous close of 6.3858) respectively. Hence, over the course of 3 trading days, the CNY had effectively weakened by 3% against the USD
Desmond Soon 28 Aug 2015
 
   

On the 11th of August, the PBoC surprised the currency markets by announcing a far higher fixing rate of 6.2298 vs. the previous rate of 6.1162 (10 August). This amounts to a 1.9% depreciation in terms of the daily fixing. Following this, the PBoC announced that the new central parity of CNY exchange rate against US dollar (USD) fixing methodology will be based on actual spot USD/CNY close on the prior day with contributions by a panel of banks and some adjustment for overnight Move in major partner currencies. On the 12th and 13th of August, the PBoC affirms their commitment to the new pricing mechanism by fixing the central parity of CNY exchange rate against US dollar at 6.3306 (vs. previous close of 6.3250) and 6.40100 (vs. previous close of 6.3858) respectively. Hence, over the course of 3 trading days, the CNY had effectively weakened by 3% against the USD.

 
Thoughts on the New Fixing Methodology
 
Against a bullish USD backdrop, this new fixing mechanism creates the situation of “a dog chasing its own tail”, accelerating the USD/CNY upside. On the 12th of August, the markets saw USD selling intervention during the last 15 minutes of trading, which suggests that the PBOC’s strategy is to contain the spot-fix basis to within a reasonable level (+0.9% 11th August) so as to avoid having to adjust the fix by an unacceptably large amount the following day [Onshore spot USDCNY closed at 6.3858 after having touched a high of 6.4489 during the day].
 
This strategy shaped up further over the next few days, with more active intra-day management of the spot- fix basis, in order to contain the market perception of how much further weakness the authorities are willing to accommodate. However, this market-oriented fixing mechanism will not be reversed. Capital account liberalisation should proceed according to previously set plans in an orderly fashion, not affected by short-term events or shocks.
 
Possible Reasons for CNY Adjustment
 
Stimulate exports. The move came three days after the dismal trade report in July, with exports falling -8.3% Year on Year (YOY) (consensus -1.5%). To be sure, there have been calls from the trade-related ministries pushing for a cheaper exchange rate, following the post-taper sell-off in Emerging Market (‘EM’) currencies. The long standing resistance by the PBoC apparently gave way to a high-level directive, at the annual summer summit at Beidaihe last week, in favour of bolstering growth in the face of cyclical challenges. Judging from subsequent PBoC statements, it appears that the initial phase of the CNY weakening -3% is largely completed and officials have described claims of a 10% depreciation as “nonsense”.
 
  Push currency reform. The bid for CNY inclusion in the International Monetary Fund (IMF’s) Special Drawing Rights (SDR) basket remains the top priority of the central government. An IMF staff report released last week highlighted the absence of a market-based “representative” USDCNY rate as one hurdle regarding SDR eligibility. The change in the central parity fixing methodology is a concrete step in what it takes to achieve a desired outcome of an IMF decision that has been delayed to September 2016, from October-November 2015 originally.
 
 
Thoughts on the Objectives of CNY Adjustment
 
  • The argument in favour of bolstering exports through a relatively minor currency adjustment is not convincing; for some time, Chinese officials have highlighted pro-growth tools at their disposal, and currency devaluation is not one of them. First, Chinese exports today are higher-value added and less price-sensitive than before. Two, in the current global landscape of weak aggregate demand, currency depreciation is likely to provide limited relief at best. Third, the policy signal sits at odds with the longer-term intent to re-orientate the Chinese economy toward domestic sources of  growth. Perhaps most damningly, today’s move could potentially lead to an unintended consequence of competitive devaluations globally and destabilise China’s financial system.
 
  • In the quest for CNY internationalisation, policy makers are finding themselves in a catch 22 situation. In order to be considered for Special Drawing Rights (‘SDR’) inclusion, the spot rate needs to be market-determined. Given the over-valuation of the CNY versus the rest of EM, such a move may fuel speculation of a prolonged stepwise depreciation, challenging the official characterisation of today’s move as “one-off”. In the absence of liquid instruments for hedging, the timing of the change is problematic in terms of policy sequencing. Chinese corporates, which have been active issuers of USD bonds in the recent years, may be vulnerable. Recent market worries over destabilising capital outflows could stay elevated.
 
  • There are two other suggestions for the policy move, neither of which we attach a high probability. Some interpreted the move as retaliation toward the IMF’s lack of support for the CNY to be included in the SDR basket, by stoking global market volatility. Others believe this represents a “Japan-style” pursuit of trend currency depreciation as a means to stimulate the stock market, which the Chinese authorities have rejected.
 
  • A plausible theory, however, is that today’s move serves a bargaining chip for SDR inclusion sooner in 2015, and not September 2016. There are 24 members in the IMF Executive Board, each with different amount of votes. A 70% majority of votes is required for formal inclusion. Under unique circumstances that involve a change in “principle”, 85% votes are required. The timing of the move, ahead of President Xi Jinping’s first state visit to the US in late-September, appears to support this theory. Indeed, the case for early SDR inclusion would go a long way in addressing US political rhetoric on Chinese currency manipulation, as a formal recognition paves the way for portfolio inflows to counter depreciation pressure. Last month, the PBoC liberalized market access to onshore bonds for foreign central banks, sovereign wealth funds and global financial organisations.

Desmond Soon is co-head of investment management, Asia ex-Japan/ portfolio manager for Western Asset Management

 

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