Chinese currency convertibility cannot be achieved overnight, JP Morgan’s Sara Yates says

The Chinese authorities have been clear that their aim is full convertibility of their currency. But this could not be achieved easily,JP Morgan Private Banking’s global FX strategist Sara Yates says.

First, we believe the authorities needed to remove the substantial distortion in the level of the currency created by it being pegged at a very low level to the USD until 2005. Consequently, the authorities have gradually allowed its currency to appreciate against a basket of currencies over the past 7 years.

USDCNY recently touched 6.12, its strongest level for over two decades. The move in the currency has brought more balance to the current
account. We also note that the pace of appreciation of the CNY versus the USD has slowed over the past year. Taken together, these factors suggest the currency is now closer to its long term fair value level than before.
With a more fairly valued currency, a next step on the road towards full convertibility is to widen the trading band. This was done in April 2012 when the authorities widened the band from +/-0.5% to the current 1% band.

However, a key difference between the conditions then and those recently is that in 2012, the spot was trading in the middle of its trading
band. Whereas, until very recently, the market’s belief that USDCNY was a low volatility, one directional trade has caused USDCNY to hug the bottom of its trading band. Widening the band in such an environment would likely see USDCNY immediately move to the bottom end of its new enclosure and not deliver the two way flow the authorities are aiming for.

Recent actions from the Chinese authorities have helped USDCNY move away from the lower end of its trading band. We believe this is a good opportunity for the authorities to widen the band. This could change the characteristics of USDCNY as it would become a more volatile pair. Though relative to currencies such as the JPY, CNY volatility is likely to
remain low.

Near term upside for USDCNY

The measures that have helped USDCNY move towards the middle of its trading band include SAFE’s introduction of a minimum net open position (NOP) limit on domestic banks’ FX loan to deposit ratio (because it has forced domestic banks to buy USDs to meet the new lending criteria). A consequence of less money flowing into the country is lower liquidity.

HSBC estimate that monthly inflows have fallen from an average of 377bn (RMB) a month to 67bn (RMB) since the NOP change. This fall in money market liquidity has been exacerbated by a seasonal lull in liquidity. With the authorities not stepping in sufficiently to ease the crunch, Shibor rates jumped substantially higher.

A potential explanation for the PBOC’s unwillingness to step in to ease money market conditions is that it reflects their determination to drain liquidity from the system and force a cleanup of the shadow banking sector. If true, this has two implications. Firstly, it suggests downside risks to Chinese growth, from a forced deleveraging of the domestic economy.
This may undermine market sentiment towards the CNY, particularly in an environment where US data is firming and the USD is outperforming. Secondly, it suggests that funding costs could remain high for a while, keeping longer dated forward points elevated. Where we see more scope for the forward points to fall is at the shorter end of the curve (as we have
already started to see).

But if the elevated carry at these shorter tenors has been an impediment to investors closing out positions, an unwind of the forward points could also be an added negative for the CNY in the near term.

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