China FX liberalization to ease reserve headache; Beijing at point of no return

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By:
Peter Garnham
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China has announced further plans to liberalize the renminbi, a move that could relieve the pressure of excessive FX reserve growth that has been triggered by the easing of the eurozone financial crisis.

Yi Gang, deputy governor of the People’s Bank of China (PBoC), said at an IMF meeting in Washington on Wednesday that the renminbi’s trading band would be widened in the “near future” as part of plans to make the exchange rate more market-orientated.

The central bank last altered the size of the renminbi’s trading band – about which it is allowed to fluctuate from the PBoC’s daily reference rate – in April 2012, raising it from +/- 0.5% to +/-1%.

“The exchange rate is going to be more market-orientated,” said Yi. “In the near future we are going to increase the floating band even further.”

He added that increasing the band would be “good for the market” and that the central bank would do it in a gradual manner so it would not cause instability.

Yi also pledged to further ease other restrictions on the use of the renminbi.

“We will steadily push the capital account convertibility reform further,” he said. “So you will see that maybe in the next couple of years, China step by step will gradually go along that direction.”

The pledge came after the renminbi hit a 19-year high of Rmb6.1723 against the dollar, the upper limit of its permitted trading range on Wednesday. Indeed, the renminbi has been trading close to its upper limit on most days since October.

The commitment also follows news that China’s foreign exchange reserves increased by $128 billion to a record $3.44 trillion in the first quarter of 2013.

The comments have seen analysts revise their forecasts for Chinese currency reform. Bank of Tokyo-Mitsubishi UFJ, for example, now expects the PBoC to widen the trading band to +/- 2% at the start of the third quarter rather than the start of the fourth quarter.

Some might see the commitment for more flexibility in the renminbi as an attempt to divert criticism of China over its currency policy from its trading partners at the G20 meeting of finance ministers and central bank chiefs that starts in Washington on Thursday.

However, such a move could also help solve the problem of what China does with its increasing FX reserves.

Those reserves have been on the rise as China has had to intervene to keep a lid on the value of the renminbi since last October as tensions in the eurozone debt crisis have faded.

Greg Gibbs, FX strategist at RBS, says an important part of the renewed demand for the renminbi reflects its positive carry.

Before last year, the renminbi typically traded at a premium in the non-deliverable forward or offshore market, meaning prices did not reflect the interest differential in holding the currency over the dollar, but was influenced by speculative pressure for the renminbi to strengthen.

However, during much of the eurozone financial crisis from mid-2011 to mid-2012, the renminbi traded at a discount in the forward market, reflecting speculative pressure for it to depreciate. Transaction data from the PBoC show that, through much of that crisis period, there was little net FX intervention and hence slower reserve growth.


 Net renminbi sold by PBoC to Chinese banks
 Source: RBS

“However, with the crisis fears in Europe faded and markets globally seeing evidence of high-yield demand, the renminbi is again seeing significant capital inflows, similar to the period before mid-2011 characterized by rapid FX reserve growth,” says Gibbs.

The main difference is that now renminbi forwards are still trading at a discount to spot, and are therefore more in line with the interest differential over the dollar.

This, perhaps, reflects the increased deregulation of the renminbi since 2010, which has opened up more avenues for financial institutions to arbitrage between the onshore and offshore renminbi capital markets.

Gibbs says that could be causing a problem for the Chinese authorities, who for much of 2011 and 2012 might have thought they had reached a degree of equilibrium in the renminbi exchange rate that required little FX intervention.

“This now appears much less clear and they are finding appreciation pressure for the renminbi return,” he says.

“This may be a reflection of the more aggressive quantitative policy measures in the US and Japan, and the financial deregulation in China allowing the renminbi forwards to trade at a discount and offer carry return.”

Therefore, China finds itself in the uncomfortable position of accumulating FX reserves it has to invest in low-yielding global bond markets.

China could, of course, combat the inflows by tightening capital controls again.

However, as Gibbs notes, there has been a lot of political capital spent in China in recent years on opening up its financial system and increasing the use of the renminbi on the global stage.

“It is often mentioned that China wants to internationalize its currency,” he says. “It is possible that they [China] have reached the point of no return and will instead try to control the pace of capital inflows by allowing the renminbi spot rate to appreciate more rapidly. In other words, make it more flexible.”

That would go some way to relieving China’s reserve headache.