China faces tough choices in currency defence as yuan weakens

AFTER a months-long effort to prop up the yuan, the People's Bank of China (PBOC) has cycled through most of its policy tools, leaving it with some tough choices.

As the currency hovers near the weak end of a daily 2 per cent trading band against the dollar, the spectre of extreme measures - however unlikely - is growing. Already, there are signs that China is intervening in foreign-exchange markets, like Japan has done. A one-time revaluation and restricting the yuan's range are other major tools.

These measures - if taken - have a significant downside, as they will drain China's foreign reserves and raise fears of stronger capital controls just as investors fret about President Xi Jinping's policy direction. Given the extremity of these options, analysts say they're likely to be a last resort, with policymakers on Tuesday (Oct 25) stating they would deepen market-based foreign-exchange reforms.

"There are way more aggressive tools that the PBOC can utilise if they want to push the yuan stronger and they have done it before," said Mingze Wu, a foreign-exchange trader at StoneX Group in Singapore. "It's feasible for PBOC to do it, but it'll come at a cost. China wants to internationalise the yuan, which includes not being too heavy handed."

While it's impossible to mount a sustained defence against a stronger dollar that has steamrolled every other currency, the PBOC has rolled out a raft of measures, limiting its drop this year to 12 per cent - a performance that's better than the yen and South Korea's won.

A 12 per cent rally in the dollar this year has pushed the yuan close to the weak end of its trading band, raising the spectre of a repeat of the experience in 2012. Back then, China's currency frequently hit the limit of the set range, fuelling a drop in liquidity which led to a virtual standstill in trading in the foreign exchange market, according to traders who were in the market back then.

Here's a look at the measures the PBOC can take to support the yuan:

Intervention

There are signs that China is already stepping up the defence of its currency, with traders saying state-owned banks sold dollars on Wednesday and Thursday. The lenders took advantage of a broad dollar-selling spree on Wednesday when the offshore yuan rose by a record.

Such intervention is the most likely option for policymakers, according to analysts and traders. It would slow the yuan's decline until China's macro fundamentals improve, said Bloomberg Intelligence analyst Stephen Chiu.

The downside to such a move is that it would erode China's foreign-exchange reserves. After the central bank devalued the yuan in August 2015 - a shock that reverberated across global markets - its reserves fell by more than 15 per cent in the period through January 2017, suggesting that it intervened. The PBOC's currency holdings dropped 7 per cent in the first nine months to US$3.03 trillion.

Another less obvious way to intervene is to dramatically boost the cost for traders to short the yuan. Beijing could engineer a spike in the funding costs by mopping up liquidity in Hong Kong - a measure it used in early 2016 and 2017. While this would trigger massive losses for speculators, it might also spur wild swings in the currency market.

Narrowing the band

In theory, the authorities can also narrow the yuan's daily trading band. The PBOC last revised it back in 2014 when it widened the range to 2 per cent from 1 per cent to allow markets to play a bigger role.

However, the central bank is unlikely to restrict the band as this would run counter to its stated aim to allow for more market-driven price action and spur doubts about China's efforts to internationalise the yuan, according to Alvin Tan, the head of Asia currency strategy at RBC Capital Markets.

Adjusting the fix

Lastly, the PBOC can initiate a one-time adjustment to strengthen the yuan's fixing, although this would again be construed as a reversal of its market reforms. The last time the authorities revised the fix was in 2015 when they devalued the Chinese currency.

China may be holding back from some of the extreme measures because unlike the yuan's sharp depreciation in 2015 and 2018, the currency remains elevated on a trade-weighted basis, according to HSBC Holdings.

"We cannot rule out the possibility of further tightening of FX control then, especially if the RMB's depreciation against a basket of currencies also hastens," said Paul Mackel, global head of FX research at HSBC. BLOOMBERG

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