Too many crowded bets on “7” for yuan-dollar rate could be dangerous

The Chinese yuan has been under pressure in recent weeks due to the double dip in recent economic data and more importantly, the escalating trade war with the U.S. Since then, the yuan has shown weakness against the U.S. dollar, breaking 6.9 to the USD, but also against major global currencies. The looming prospect of the China-U.S. relationship, as well as a likely continued lax monetary policy in China, has all pointed to a weaker yuan, at least in the short term.

At this juncture, there is now a heated debate as whether it will hit “7” or, to put it in another way, if “7” is an unbreakable magic number. So far, the market seems to believe that the People’s Bank of China (PBoC) has a floor on the dollar-yuan rate at “7”.

Is this really the case? We do not believe so.

To predict the behavior of the PBoC’s intervention, the first question is to ask is what the rationale behind the intervention is. In this round of intervention, the most notable reason to fend off depreciation could be to avoid the negative effect of rapid depreciation on accelerated capital outflow and business confidence, which could further drag down China’s already shattering economy. Based on the net reduction in U.S. Treasuries holdings and the use of its countercyclical factor, the PBoC seems to have conducted sizable forex intervention to keep the yuan stable. But it is vital to note that China’s key concern is growth and yuan stability is increasingly important to achieve this goal but not a specific ceiling at “7”.

What’s more, bear in mind that the PBoC choose to safeguard the currency at the moment because it is benefiting to shore up investor’s confidence which has been affected by the escalating trade war. It may not always be the case. China’s exports have started contraction since November 2018, and an overvalued currency will only increase the unit cost for exports and thus harms export growth. The cost problem has been particularly worrisome if the U.S. further raises tariffs to more products importing from China. Once Chinese exporters start to feel more from the cost of exports and less from the sentiment, the PBoC will find it much more reasonable to depreciate its currency, at least to temporarily offset the negative impact of the tariffs. Another big push which may change the behavior is the PBoC’s intention to weaponize the exchange rate in the trade war with the U.S.

In fact, the PBoC has never announced any particular level that it wants to defend or explicit rule it is willing to follow, so the betting by the market analysts on 7 seems completely drawn from the belief in the “focal point”. This can be dangerous. In the context of China, history never guarantees any particular level for the yuan since the foreign exchange system reform in 2005. Yuan volatility against the USD has increased significantly after 2016, echoing the PBoC’s announcement to enhance the two-way volatility of its currency. In other words, the PBoC has definitely realized that any one-way betting on the CNY could only dampen its efforts to control the currency.

For the PBoC, safeguarding the currency is only to support growth, and there is no reason to keep a magic number and sacrifice growth. This is especially so when the market started to bet on the number. This means that, although the PBoC is willing to push for the stability of the dollar-yuan rate, it would avoid wasting too many bullets to defend 7. The best strategy for the PBoC is to lean with the wind for forex intervention rather than against the wind, as the latter is clearly more costly. As such, the PBoC needs to introduce more two-way volatility. This is exactly what the PBoC did in early 2014 when it tricked the market by engineering a mini devaluation of the yuan against the USD against the background of a one-way bet for appreciation.

All in all, while the market is likely to see the PBoC intervening in the yuan market, we do not think “7” should be considered a ceiling. The objective of yuan stability is to avoid rapid capital outflows which could shake investor’s confidence. But to that end, the problem for the PBoC is not a fear of the magic number 7 but instead too crowded trades betting on the one-way movement of the yuan. Bear in mind that the PBoC has repeatedly reminded the market about its higher tolerance of two-way movements in exchange rate. Relying too much on a specific point will only make it more difficult for the PBoC to discretionarily safeguard the foreign exchange market. If the investors start to speculate on one number, the PBoC will do its utmost to make them pay as it did in March 2014.


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