(Bloomberg) -- Monitoring how the People’s Bank of China handles its “managed float” system for the foreign-exchange market isn’t easy. The central bank has various tools at its disposal - some are more transparent, like the daily reference rate, while others are murky, such as the potential for Chinese authorities to secretly urge banks not to bet against the yuan in proprietary trading. With the currency once again near the weak end of its allowed trading band — and close to a record low offshore as a potential trade war looms — risks are rising that authorities may step up efforts to stabilize it.
1. How important is the daily fixing?
It’s the most obvious tool the PBOC has to influence the currency. It sets a reference rate each trading day at 9:15 a.m. Beijing time, around which the yuan is allowed to move 2% in either direction. The rate takes into account factors including the prior day’s official close at 4:30 p.m., the yuan’s move against a basket of currencies and changes in other major exchange rates. Encouraging declines at the official close allows the central bank to set weaker fixings without sending a strong signal on policy or destabilizing markets. A reference rate that’s significantly stronger or weaker than the market’s expectations is typically considered a signal from Beijing.
2. How has it evolved?
The fixing has gone through rounds of reform over the years.
To make it more market-based, China started to allow the yuan to trade within 0.3% of the fixing against the dollar in January 2006, widening that to 0.5% in May the following year, 1% in April 2012 and 2% in March 2014. In August 2015 China devalued the onshore yuan in its most dramatic foreign-exchange reform in a decade.
To make the fixing more transparent, the PBOC laid out the factors that banks need to consider as they submit prices for the rate.
3. How can the PBOC guide the fixing rate?
In 2017, the PBOC introduced a “counter-cyclical factor” in the fixing formulas that commercial banks use to calculate and contribute to Beijing’s daily reference rate. The move was made to avoid a fixing that the central bank deemed excessively weak. The component was removed and then reinstalled in 2018, before lenders stopped using the factor in October 2020. Market speculation of a further reintroduction to support the yuan emerged in 2022 as the fixing rates’ gap versus forecasts widened to levels that couldn’t be explained by calculations based on a regular fixing model.
The fixings’ deviation from estimates has become more visible since 2023, making it a stronger clue as to where the PBOC’s “line in the sand” is. For most of last year, the fixing was stronger than estimates, with the yuan under pressure from soft Chinese growth, a lack of forceful stimulus and US tariff threats. In evidence of the reference rate’s huge impact on the market, a slight drop in March 2024 jolted global currencies as it fueled speculation about depreciation risk.
Since Donald Trump’s victory in November’s US presidential election bolstered the greenback, the PBOC has been drawing a closely-watched line by setting the fixing at levels stronger than 7.20 per dollar.
China could strengthen the fixing’s impact to the market by maneuvering banks’ pricing. Some banks that submit fixing quotations were said to have tweaked their models to lean against the yuan weakness in August 2022, without attributing the change to a reinstatement of the counter-cyclical factor. There were suggestions the tool was being deployed again as the yuan weakened in mid-2023.
4. What else can the central bank do?
One of the latest tools for the PBOC is the so-called foreign exchange reserve requirement ratio that sets the amount of foreign currency deposits banks need to hold as reserves. A change allows the central bank to fine-tune liquidity in the banking system; for example, cutting the ratio will ease the supply of foreign currency, thus propping up the yuan. The PBOC raised the ratio twice in 2021, to 9% by the end of the year, then cut it three times in 2022 and 2023 to 4%. Before those changes, the ratio hadn’t moved since 2007.
5. What about less formal measures?
State-owned banks selling the dollar versus the yuan in spot trading is seen by market a type of shadow intervention, which occurs from time to time.
Since 2023, traders also observed large transactions from the lenders in the foreign-exchange swap market, another method which could prop up the yuan. The banks borrowed dollars via swap contracts which can be sold in the spot market to support the yuan.
Chinese officials aren’t averse to talking their currency up or down when needed. The PBOC’s standard line is that the yuan will be kept basically stable at reasonable, equilibrium levels, while stronger verbal intervention could appear in multiple forms. The official comments seen since 2022 aimed at bolstering the yuan involve the requirement on banks to respect “the authority of the fixing,” pledge to adopt comprehensive measures and stabilize expectations, to “resolutely prevent risks of big fluctuations” or to crack down on behavior that disrupts the market and prevent the building of one-sided bets as well as an overshoot in the exchange rate.
In addition, to guide market expectations, the PBOC tends to cite statements from the China Foreign Exchange Committee, an industry organization founded by key participants in the onshore market under the guidance of the regulators. Some of the comments can be targeted at specific trading. In 2023, Chinese regulators reminded traders of their increasing attention toward stress on the yuan in a slew of actions, including urging brokers to cut back proprietary trading, ordering lenders to report on currency trading data and conducting surveys among market participants about capital flows.
6. What can be done against speculation?
Driving up the cost of betting against the yuan offshore was favored as a tactic when China wanted to curb declines during years including 2016, 2018, 2023 and possibly early this year. The key is to mop up liquidity so traders have to pay higher interest rates to borrow the yuan. That can be achieved by having agent banks buy the currency or decline to lend their supply to other banks. The PBOC can also increase yuan bill issuance in Hong Kong, which is by far the biggest market. It announced a plan to issue a record 60 billion yuan in bills in January. For the onshore market, the PBOC had additional tools to boost costs for yuan bears. The PBOC in 2022 re-imposed a risk reserve requirement of 20% on currency forward sales by banks to clients, a tool it had deployed during the China-US trade war from 2018 to 2020. The move puts a punitive fee on speculative trades in the derivatives market, raising the cost of bets to short the yuan.
7. How about capital controls?
Controlling the flow of funds in and out of the country is one of the bluntest instruments. China moved to limit outflows in the wake of the yuan’s devaluation in 2015 — imposing restrictions on everything from overseas takeovers by Chinese companies to consumers buying insurance policies in Hong Kong — and there has been little sign of a let-up. As the US Federal Reserve began to tighten monetary policy in 2022, Chinese state-owned companies were asked to exercise greater caution in new overseas spending and investment plans. The central bank could also tweak the limits of overseas borrowing or lending for financial institutions and corporates, as was seen in early 2021.
In 2022 and 2023, the PBOC adjusted some rules to allow onshore companies to borrow more overseas, which might also help increase foreign capital inflows.
Conversely, the government fostered capital outflows during the yuan’s advance in 2021 by initiating new channels with Hong Kong for mainland investors to tap the offshore bond market and wealth management products.
8. What about foreign reserves?
China’s foreign reserves are among the world’s largest at more than $3 trillion. Policy makers sold billions of dollars in the aftermath of the 2015 devaluation to support the yuan. While this can be a useful indicator, it is also influenced by broad gains in the dollar, which can lead to a drop in China’s reported reserves. These declines aren’t necessarily a result of intervention, but rather because non-dollar assets in China’s stockpile will have depreciated against the dollar.
--With assistance from Ran Li.
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