from Follow the Money

China still pegs to the dollar …

November 28, 2005

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And it intervenes in a big way in both the spot and the forward market.  But it doesn't manipulate its currency.  At least not technically.   The US Treasury - in a widely telegraphed move - decided to give China more time to discover the joys of a more flexible currency.

Andy Mukherjee - quite correctly - notes that China did not really adopt a basket peg this summer, nor did it move toward a more flexible currency regime.  It basically has the same currency policy it had before July.  The RMB is worth a bit more now than it was in July, but China still pegs to the dollar - not to a basket of currencies.  

The US cannot complain too much though about China's failure to adopt a basket peg.  After all if China really had adopted a basket peg, it would have let the RMB depreciate against the dollar to offset the dollar's recent appreciation v. the euro and the yen.   Instead it has let the RMB appreciate ever so slightly v. the dollar.

The US doesn't really want a more flexible RMB.  It wants a stronger RMB.

With reason.   China missed the right time to shift to a basket peg.  Think 2002, before the dollar fell.   And it probably needed to do more than just adopt a basket peg - it also need to let the RMB appreciate against the basket over time.  That would have meant the RMB would have risen in line with Chinese productivity growth ... but that's dreaming.

Back in the real world, China is trying to manage the economic and political consequences of following the dollar down, then back up (though the move up is not yet comparable to the move down). 

Mukherjee is right about something else too.   If a sudden shift in Chinese exchange rate policy delivers a jolt to the world economy, that jolt will come when China's policy actually changes - not this year.   Economically, China's small move had next to no impact.  Politically, a repeg wrapped in lots of rhetoric about flexibility worked.   Schumer-Graham got pushed off by a year.  And China gave the Treasury just enough to make the Treasury comfortable clearing China of currency manipulation.

China claims that the repeg has had an economic impact, as it has reduced speculative pressure on the RMB.  China's central bank likes to note that the offshore futures market is expecting a relatively small future revaluation right now. 

Count me unconvinced.  As usual, I want to see the full data on China's reserve increase for the second half of this year.  We know what happened through September, but we are now almost in December.

China's State Administration of Foreign Exchange claims that capital inflows from China have slowed a bit, and China is running a smaller capital account surplus now than in 2004.   Perhaps. 

We should know more after China releases a bit more data.

But remember two things:

  • Valuation changes dramatically increased the value of China's euro denominated reserves in the fourth quarter of 2004, when China's reported dollar reserves really soared.  And valuation changes have reduced the value of China's euro denominated reserves this year.
  • A big chunk of Chinese capital flows are so called errors and omissions - basically, the gap between recorded changes in reserves and recorded capital inflows.   Until China starts reporting valuation changes separately, I would suspect valuation changes added to unrecorded capital inflows last year - and are subtracting from them this year.  In other words, capital flows to China were a bit weaker than they looked in 2004, and will be a bit stronger than they appear to be at first glance in 2005.

Just a hunch though. 

I also suspect that the forward price of the RMB is increasingly being influenced by the People's Bank of China.

The PBOC certainly is now active in the new "onshore" forward market.   Last week, China's central bank entered into a large currency swap with a bunch of Chinese banks.  It sold dollars for RMB today - and agreed to buy those RMB back next year at a rate of 7.85 to the dollar.   That was well inside the forward price of RMB in the "offshore" forward market (NDF market).   And it consequently led the forward price of the dollar [edited; thanks Sun-bni] to rise in the offshore market.   Dan Slater of Finance Asia:

On Friday, China's central bank, the People's Bank of China (PBOC) executed an inaugural foreign currency swap with ten of the country's domestic banks, including the four state-owned commercial banks that dominate the banking system, and a number of policy banks. Under the terms of the $6 billion deal, which is to be repeated on a fortnightly basis, the Chinese central bank sells the dollars at the prevalent spot rate to the domestic banks, which will swap the dollars back into Rmb in 12 months time, at a rate set at Rmb 7.85 to the dollar.

This rate compares to a spot rate of 8.0805 and a non-deliverable forward rate (used by offshore investors to hedge their Yuan positions) of 7.76 before the announcement and 7.78 after the announcement. The swap rate, which is 2.86% lower than the spot rate to the dollar, is being closely watched as an indicator of the government's intentions regarding the currency....  Opinion is split as to whether the swap rate indicates the setting of a floor or of a ceiling to the currency's future movements.

The NDF rate rose to 7.78 after the announcement, with some traders saying this reflects sentiment that the central bank is guiding expectations towards only a mild revaluation of the dollar by year-end. But one trader says that the narrowing of the NDF rate over the onshore rate was because the swap deal provides an obvious arbitrage to banks, since the price at which they can buy dollars offshore is lower than the rate at which they have to sell back to the central bank. It was this realization that caused the spike in the offshore rate, because the markets are not very liquid.

China claims that this transaction was intended to help develop a true hedging market. 

Maybe.

But I remain struck by the fact that China's central bank seems far more willing than the local banks to sell insurance against a big increase in the RMB.   That may be because selling insurance against an increase in the RMB amounts to selling insurance against a change in the government's policy - and only the government is willing to insure against a big change in its own policy.

But, as our resident quant Joseph Wang consistently points out in the comments section, holding a bunch of RMB on deposit (where they can collect interest) is another way of hedging against a big increase in the RMB, and presumably local Chinese banks selling forwards could easily hold offsetting RMB positions ...   

Right now, the banks are effectively betting against the central bank; they make money on this swap if the RMB rises above 7.85  next.  Think of it as one part of the Chinese state (the state banks) betting against another part of the state (the central bank).  Frank Gong of JP Morgan, cited by Bloomberg:

``The significance of the move is that all the domestic banks and the PBOC agreed on the one-year forward rate of 7.85,'' said Frank Gong, chief economist for Greater China at JP Morgan Securities Asia in Hong Kong. ``The yuan has to be stronger than that in one year for the banks to be in the money.''

The most interesting explanation for the swap I have seen comes from Claudio Piron (cited in Slater's article).  Piron argues that the swap will help the PBoC manage large fx inflows, as the swap is a substitute for more sterilization bill issuance.

Money market rates are so low because of the liquidity caused by the large forex inflows. Frank Gong, JPMorgan's China economist, who foresees the Rmb strengthening by 13% by the end of 2006, adds that although the central bank will lose money on the swap the more the currency appreciates, this does not rule out that the Rmb will be allowed to strengthen.

"The central bank has $800 billion in foreign reserves, so it will take a loss whatever happens. For the central bank, strengthening the banks is a policy not a commercial issue," he says.

Claudio Piron, JPMorgan's Asia FX strategist says he believes the significance of the deal is that it provides another way for the central bank to manage liquidity. "The central bank has withdrawn Rmb out of the system via the swap, so this is an alternative to issuing more bills and further driving down interest rates," he notes.

As to whether or not the 7.85 level set for the deal indicates the potential for further revaluation, Piron takes the view that the level was chosen precisely to prevent further speculation; indeed, possibly even to set a benchmark for the currency in the absence of reliable interest rate indicators on the mainland.

"The difference between the swap rate to the spot rate (2.86%) is roughly the same as the difference between Chinese interest rates and US interest rates. So a speculator would not gain anything by betting on the Rmb," he says.

I certainly agree with Frank Gong's argument that the central bank will take a loss no matter what happens!  So committing to buy dollars at 7.85 should not preclude the central bank from allowing greater RMB appreciation.  I would only add that money market rates are low because lending constraints have forced the banks to lend out less than they are taking in - effectively creating a captive market for PBoC sterilization bills.

Countries like Brazil and Turkey also are sterilizing capital inflows right now; they just pay a much higher rate on their sterilization bills.

However, the longer the central bank relies on lending curbs to create a captive market for low yielding sterilization bills, the more it cuts into the banks' profits - and the banks capacity to recapitalize themselves with their ongoing profits.   So the current policy has a cost - albeit a very well hidden cost.

UPDATE: Sun-Bin's take on the swap ... .

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