China tightens grip on yuan to head off economic risks

[BEIJING] In rapid fire moves that have stunned investors, Chinese authorities have begun tightening control over the yuan, lifting it sharply in a concerted effort to restore market confidence and forestall risks of capital outflows and slower growth, policy insiders say.

Caught off-guard last month by a ratings downgrade by Moody's Investors Service that gave fresh momentum to bearish yuan bets, traders said Beijing has reverted to its old play book - intervening in markets to bend them to its will.

The key priority for authorities was maintaining market confidence ahead of a leadership transition later this year, policy insiders said, as growing debt risks, higher US interest rates, capital outflows and possible trade tensions with the United States threatened to knock the economy.

The policy insiders say last month's introduction of a mysterious 'counter-cyclical factor' that increases the central bank's influence over the yuan's reference rate showed how serious authorities are about flushing out bearish bets and heading off any slide towards 7 yuan to the US dollar.

The move highlighted the challenge China faces between safeguarding economic and currency stability and speeding up capital market reforms - important steps in its quest to internationalise the yuan.

"They (authorities) are clearly tightening their grip (on the yuan), which is related to politics and diplomacy," said a policy adviser.

"From monetary authorities' perspective, they definitely do not want to see the yuan falling past 7 - a landmark move that could affect market expectations," the adviser said.

The People's Bank of China (PBOC), responding to Reuters' request for comment, denied suggestions that it's tightening control on the yuan via the counter-cyclical factor.

"Such a statement is not true," the PBOC said in a rare email response, and reiterated the official explanation that changes to the way the mid-point is calculated were geared to better reflect macroeconomic fundamentals and temper "irrational" market expectations.

Beijing is especially sensitive to any renewed criticism of its currency policy by the United States, and a weaker yuan could play into President Donald Trump's protectionist proclivities as Washington engages in 100 days of trade talks with China.

A second adviser said that with the Federal Reserve set to raise rates further at next week's policy review, authorities are worried that capital outflows could drive persistent weakness in the yuan - the last thing Chinese leaders want before the closely-watched leadership transition in the autumn.

In 2015, a botched stock market rescue attempt tarnished Beijing's reform and broad policy-making credentials.

The yuan has gained 2.2 per cent versus the US dollar this year, including 1.3 per cent since May 24 - when Moody's downgraded China's credit ratings for the first time in nearly 30 years, citing its mounting debt risks.

A Reuters poll predicted the yuan to slip toward 7.05 per US dollar in 12 months.

Policy insiders believe authorities had been experimenting with the new mid-point regime and may have been forced to introduce it early after the Moody's downgrade. The central bank meanwhile has also aggressively strengthened the mid-point since the start of the month.

Authorities are also concerned that rapid falls in the yuan, which is allowed to trade two per cent above or below the mid-point rate, could undermine Beijing's bid to boost the Chinese currency's global clout.

"The central bank will use various means to intervene if the yuan falls to 7 - this is a so-called red line," another policy adviser said, underscoring unease that a destabilising fall in the yuan could sap confidence and hurt the economy.

China burned through nearly US$320 billion of reserves last year but the yuan still fell about 6.5 per cent against the US dollar, its biggest annual drop since 1994. Latest data showed foreign exchange reserves rose to a seven-month high of US$3.054 trillion in May, as stringent capital control measures helped staunch outflows..

Policy insiders say the central bank will combine the 'counter-cyclical factor', with its regular currency interventions and existing curbs on capital outflows to support the yuan.

The change will make it harder to speculate on the yuan, but critics say the move undermines transparency of China's currency regime - a goal of recent market-based reforms.

"The central bank's mid-point move is a step closer to the previous fixed exchange rate," said one of the advisers.

"The move is controversial as it's a retreat in reform."

REUTERS