The country’s central bank faces tough choices over the pace of reform, but is likely to err towards the side of change over stability and only intervene in spot prices periodically to deter excessive speculation, according to Ju Wang, senior Asian FX strategist at HSBC. “This would see the recent status quo maintained for all three RMB curves in the short term,” she said. “In this light, the best strategy remains being short the long-end spreads between the dollar-renminbi and dollar-renminbi NDF [non-deliverable forward] curves, given the positive carry.”
She argues that Beijing has five policy options in terms of currency liberalization. The first is to maintain the status quo and wait for the market to self-correct.
“However, it may be difficult to sustain this policy, particularly if Europe and the US manage to get greater traction on solving their debt concerns, even for a temporary period, as positive sentiment would increase downward USD/CNY pressure,” she said.
The renminbi is likely to perform well throughout the rest of this year and the first quarter of 2013 due to seasonal and cyclical factors, so downside pressure on the dollar-renminbi is likely to remain in the near term, she said. If this continues, the PBoC could feasibly adjust FX policy to clear the dislocation in the market.
The second scenario could see the central bank return to its previous policy of aggressively buying dollars, providing the demand needed at the bottom of the daily band.
“In our view, many billions of RMB liquidity would be released into the system, which could lessen the need for further RRR [reserve ratio requirement] cuts,” she said. “The onshore forward curve would flatten and interest rate parity would be less visible.”
By her calculations, the PBoC would have needed to buy the dollar equivalent of Rmb100 billion to Rmb130 billion ($16 billion to $20.9 billion) each month for the past three months to soak up all of the inflows. However, as central bank action has been limited since September, she argues that there are around Rmb300 billion to Rmb400 billion of long US dollar positions held by banks or corporates that have not been cleared through the system.
“If the PBoC were to resume its previous, aggressive [US dollar] buying programme, then the amount of RMB liquidity pumped into the onshore market would be around this sort of size,” said Wang. “This is also nearly equivalent to a 50bp [basis point] RRR cut.”
The third option would be to move the dollar-renminbi fix sharply lower to close the gap with the spot rate, she said. This would lead to a swift fall in the dollar-renminbi swap.
“Furthermore, it may take a sizeable amount of CNY appreciation before the market reaches equilibrium, which in turn could challenge the outlook for exports,” said Wang. “As such, while we think the USD/CNY fix is becoming gradually more market-driven, we do not think it will be shifted significantly lower in the short term.”
Fourthly, the central bank could choose to widen the dollar-renminbi band from its current width of plus or minus 1%. This would have a similar effect on the spot market as moving the fix lower, but there would be more room for flexibility on a daily basis.
“However, the level of the short end NDFs may not drop as aggressively,” added Wang. “The NDFs would still be priced off the fix – which would remain on a gradual downward trend – rather than the spot rate, which would move lower more quickly. As such, the convergence between the two offshore forward curves – NDF and CNH – would be less likely to occur, assuming the fix remained relatively stable.”
Finally, the PBoC could aggressively fix the currency to reverse renminbi appreciation expectations. This would ease appreciation pressure in the short term, but if the exchange rate remains well above a near term equilibrium level and the market continues to support a longer-term RMB appreciation view, then the effect might not last.
“In a knee-jerk reaction, the three RMB curves may shift to the right and the curve could steepen a bit,” said Wang. “But the curves would soon flatten again, to price in more appreciation in the future.”
She pointed out that these five options are not mutually exclusive, but on the whole the central bank is most likely to stick to the first one, keeping away from intervention as much as possible, while allowing the dollar-renminbi fix to move gradually lower.