Blockbuster! What signal did the Pboc send? Could the yuan appreciate further?

On October 9, the first trading day after the National Day holiday, the Chinese currency strengthened by more than 1,000 points again, with both the onshore and offshore RMB rising above 6.70, the highest level since April last year. In 2020, the RMB exchange rate soared, especially since May, with a cumulative increase of nearly 6 percent. In the last three quarters, the onshore renminbi rose 3.89 per cent against the dollar, its biggest quarterly gain since the first quarter of 2008. For the RMB crazy fluctuations, there are analysis that this is like the exchange rate when the storm fluctuations.

For the crazy rise of the RMB, some analysts believe that the continued weakness of the US dollar index, coupled with the strong fundamentals of the Chinese economy, has driven the RMB exchange rate against the US dollar to strengthen significantly since June this year. The renminbi has risen nearly 6 per cent against the dollar since the start of June. Meanwhile, while the dollar index is now firmly above the 93 mark, it is down nearly 7 per cent from its late May peak near the 100 mark. A large amount of liquidity provided by the Federal Reserve in a short period of time leads to excessive dollar liquidity, and excessive money supply will inevitably lead to currency depreciation.

Generally speaking, if the market expects the yuan to depreciate in the future, traders will tend to buy dollars to prevent the purchasing power of their money from declining. If the yuan is expected to appreciate in the future, traders will sell dollars and trade fewer of them. To see the appreciation of RMB, take an example related to residents’ life. According to the annual exchange quota of 50,000 US dollars for Chinese residents, if calculated based on the annual exchange quota of 100,000 US dollars for families, the exchange amount in May would be 719,000 RMB. In October, the minimum amount would be 669,000 RMB, a difference of more than 50,000 RMB.

Although RMB exchange rate appreciation can reduce import costs, stabilize cross-border capital flows and boost the capital market, too fast appreciation will also hurt the export sector to some extent and have a certain negative impact on economic recovery. On October 10, the People’s Bank of China (PBOC) made a decisive move: from October 12, 2020, the reserve ratio for foreign exchange risk of forward sale business will be lowered from 20% to zero. This is after the central bank raised the foreign exchange risk reserve ratio for forward foreign exchange sales to 20 percent from zero in April 2018.

‘Since the beginning of this year, the RMB exchange rate has been floating in both directions based on market supply and demand, with greater flexibility, stable market expectations, orderly cross-border capital flows, stable operation of the foreign exchange market and balanced market supply and demand,’ the statement said.

To this end, the People’s Bank of China has decided to lower the foreign exchange risk reserve ratio from 20% to zero starting from October 12, 2020.

Going forward, the PEOPLE’s Bank of China will continue to keep the RMB exchange rate flexible, stabilize market expectations, and keep the RMB exchange rate basically stable at an appropriate and balanced level.

After August 11, 2015, in order to curb excessive fluctuations in the foreign exchange market, the Central bank incorporated Banks’ forward foreign exchange sales into the macro-prudential policy framework and charged foreign exchange risk reserves to financial institutions engaged in forward foreign exchange sales on behalf of customers.

In The reform of the exchange rate on August 11, 2015, the RMB exchange rate depreciated rapidly, and the People’s Bank of China issued foreign exchange risk reserves for the first time. In 2017, when the exchange rate stabilized, the policy was withdrawn; In 2018, the RMB exchange rate depreciated rapidly due to the trade war, and the central bank started to raise this risk reserve again. Since May, the yuan has been too strong, so the central bank has removed risk reserves again,

After the reform of the exchange rate on August 11, 2015, in order to curb excessive fluctuations in the foreign exchange market, the People’s Bank of China incorporated the forward foreign exchange sales business of Banks into the macro-prudential policy framework. Since October 15 of the same year, financial institutions engaged in forward foreign exchange sales business on behalf of customers will be charged with foreign exchange risk reserves, with the reserve ratio set at 20%.

On September 8, 2017, cross-border capital flows and supply and demand in the foreign exchange market returned to balance, and market expectations became more rational. The People’s Bank of China promptly adjusted the counter-cyclical macro-prudential management measures introduced earlier to curb pro-cyclical fluctuations in the foreign exchange market, and adjusted the foreign exchange risk reserve ratio to 0.

In August 2018, the foreign exchange market showed some signs of pro-cyclical volatility due to trade frictions and changes in the international currency market. In order to guard against macro financial risks and promote sound operation of financial institutions, the People’s Bank of China (PBOC) decided to raise the reserve ratio for foreign exchange risks in the forward sale business again from 0 to 20 percent from August 6.

As a whole, from 2015 to date, the collection of foreign exchange risk reserves by financial institutions engaged in forward foreign exchange sales on behalf of customers from zero to zero, from zero to zero, and then from zero to zero this time, the role of periodic regulation is obvious. Some analysts pointed out that this actually means that, in the short term, the RMB exchange rate is basically set at 6.7.

Wen Bin, chief researcher at China Minsheng Bank, previously said, “The foreign exchange risk reserve ratio is a countercyclical adjustment tool, which can prevent excessive appreciation or depreciation of the RMB and realize two-way fluctuation of the RMB against the US dollar at a reasonable and balanced level.”

What is the risk reserve for forward foreign exchange?

Forward sale of foreign exchange business is a kind of exchange rate hedging derivatives provided by Banks to enterprises. Enterprises can avoid future exchange rate risks to a certain extent through forward purchase of foreign exchange. However, as enterprises do not purchase foreign exchange immediately, Banks need to purchase foreign exchange in spot market accordingly, which will affect spot exchange rate, and in turn affect enterprises’ forward purchase of foreign exchange.

According to the Notice of the People’s Bank of China on adjusting the policy on foreign exchange risk reserve, the business scope of collecting foreign exchange risk reserve is as follows: 1. Specific include: customers forward foreign exchange sales business; The client call or put option business and the option portfolio business consisting of multiple options; Foreign exchange swap and currency swap business where the client does not exchange principal at the proximal end but exchange foreign exchange at the distal end; Other business of customers’ forward purchase of foreign exchange. 2. Flat position in the domestic inter-bank foreign exchange market generated from the similar business overseas conducted by overseas financial institutions with their clients. 3. Forward business in RMB purchase and sale business.

In simple terms, it means that Banks need to pay reserve funds (20%) for the forward purchase of foreign exchange on behalf of customers and other businesses. Banks pass on the cost of these reserves to their customers, which in turn is reflected in the price of forward purchases of foreign exchange. So the policy will affect the exchange rate and also guide market expectations.

Appreciation of the RMB exchange rate has positive effects, such as reducing import costs and boosting domestic capital markets. But the appreciation is too fast to the local entity and export foreign trade enterprises is certain harm. At this time, the central bank will reduce the cost of Banks’ forward sale of foreign exchange, thus reducing the cost of enterprises buying dollars, increasing the demand of enterprises’ forward purchase of foreign exchange, and encouraging the market to buy dollars forward.

WenBin believes that the recent appreciation against the dollar, as the foreign exchange risk reserve rate cut to zero, on the one hand, help the yuan against the dollar remains at a reasonable and balanced level, on the other hand also help Banks reduce long-term sale cost, increase the enterprise demand for the product, in order to better use derivatives to manage foreign exchange risk.

What is the signal the central bank is sending?

For the adjustment of risk reserve requirements, analysis, the recent strong rise of RMB exchange rate, the risk reserve rate from 20% to zero, and in September 2017, when the market environment and the central bank’s operations, reflects the central bank wants to exchange rate stay at a reasonable and balanced level, rather than forming obvious unilateral market expectations of appreciation or depreciation, by deepening the reform of marketization of exchange rate formation mechanism, develop control macroeconomic exchange rate and balance of payments automatic stabilisers.

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