On November 29th, the onshore spot exchange rate of the RMB against the US dollar in the interbank market hit the upper limit of the 1% trading band once again, marking the 22nd time it has done so in the last 26 trading days. Just a year ago, the RMB/USD spot exchange rate had been declining for 12 consecutive sessions. This year, we've seen a noticeable shift, with the currency appreciating more frequently and touching the upper limit more often.
Interestingly, despite this rapid appreciation, there's no clear evidence pointing to a surge in "hot money." Unlike previous episodes of one-way appreciation, the central bank has been purchasing foreign exchange less frequently in the market to stabilize the exchange rate. This time around, while the central parity rate has remained fairly steady, direct intervention has been minimal. The recent series of "upper limits" have passed relatively calmly.
However, commercial banks are feeling the pressure more acutely. With limited trading activity and flat markets, some banks have resorted to pushing exchange rates beyond the 1% trading band for their clients' trades, while others have used short-term RMB forwards to circumvent trading range restrictions. These are stopgap measures rather than long-term solutions to the dysfunction in the FX market.
From the central bank's perspective, reducing intervention has led to slower growth in base money, while conducting reverse repo operations to release liquidity has aimed to boost monetary policy independence. Yet, the challenge remains of balancing tight interbank liquidity with the need to manage macroeconomic and financial risks. This delicate balancing act is being closely watched.
Many analysts attribute the swift appreciation to the impact of the Fed's QE3, but stock market declines and property market regulation don't support the notion of a massive influx of speculative capital. Data doesn't show a significant acceleration in hot money flows either. For instance, in October, despite an increase in FX settlement surpluses, both FX settlement and sales volumes dropped compared to the previous month, maintaining a deficit overall.
Cross-border income and expenditure figures also reflect capital outflows. Domestic banks reported a 4.9% drop in foreign-related income and a 6.3% fall in expenditures, leading to a $5.3 billion deficit. The mainland has also maintained a net outflow of funds to Hong Kong.
"The statistics for October do not indicate a substantial increase in cross-border capital inflows," a spokesperson from the State Administration of Foreign Exchange noted during a press briefing on November 21st.
Moreover, since October, several banks have cut small foreign currency deposit rates, with the adjusted one-year USD deposit rate dropping to just 0.70%. This could be driving customers to convert foreign currency more quickly.
The sudden increase in USD supply, coupled with the central bank's reduced appetite for purchasing dollars, has created extreme imbalances in supply and demand. Banks are required to flatten their positions, yet the central bank continues to control the exchange rate via the central parity rate. Last year, the RMB's sharp depreciation was partly due to overly high pricing. Now, the central parity rate seems to be set too low, contributing to the daily upward movement of the spot rate at the start of each trading day. Unless the central bank intervenes, this pattern is likely to persist, according to a senior trader.
Traders are becoming adept at navigating the fixed exchange rate environment. In the past 26 trading days, major banks have been directed to buy dollars only four times, briefly breaking the "upper limit."
"(USD) has been falling daily, making the market illiquid, and it's too tiresome to monitor," lamented one foreign trader.
Smaller banks, having fewer balanced positions, face greater pressure to flatten their books, sometimes resorting to suspending FX settlement. State-owned banks, with more manageable FX exposure, experience less pressure.
To circumvent constraints, some banks have raised their quoted prices for clients. For example, if the daily limit is 6.2289, a bank might quote 6.2250 to customers who can still settle at that rate. "Quotations to clients are more market-driven than interbank spot rates and serve as a form of price protection for banks," explained a senior trader from a state-owned bank.
Simultaneously, some banks are employing short-term RMB forward transactions to bypass intraday trading range limitations. "One-day USD/RMB forwards were rarely done previously, but they've become quite common lately," noted a foreign-invested trader. For instance, the spot market settles trades two days later, whereas the one-day forward settles three days later, allowing the RMB spot rate to reach a higher price. If the daily limit is 6.2230, the forward price might be 6.2220 or higher.
On November 29th, the USD/RMB forward exchange rate opened at 6.2200, 81 pips below the spot price of 6.2281, with the intraday low reaching 6.2030, or 256.4 pips below the spot price. "Banks are returning customers, and though the spread has narrowed, there's still no buying pressure," said the trader.
Another tactic banks are using involves indirect currency swaps between the RMB and non-USD currencies like the euro, yen, and Hong Kong dollar, given the wider trading bands for these pairs.
Besides self-help, banks are also capitalizing on the renewed appreciation trend. Recently, some banks and large importers have revived arbitrage combinations, splitting import and payment businesses into three parts. Customers first buy foreign exchange with RMB, then take out a foreign currency loan, and finally lock in the exchange rate with a forward contract. "The bank secures deposits, the account manager earns bonuses, and the company benefits. It's a win-win," disclosed a shareholder.
However, unlike the previous period of one-way RMB appreciation, this time the currency has appreciated significantly in the short term but has depreciated over the long term. The above trading model is no longer risk-free arbitrage.
"Although RMB deposit rates remain high and foreign currency financing rates are low, long-term forward purchases mean higher costs for customers. The interest on RMB deposits isn't enough to cover the financing costs and losses from foreign exchange purchases. It's not cost-effective, but some banks guide customers to do this for deposit and loan business, and some return the proceeds from long-term forward purchases directly to companies as financial expenses," explained a senior banker from a state-owned bank.
As the RMB resumed its appreciation trajectory in late August, foreign exchange reserves haven’t rebounded sharply. Notably, the central bank’s foreign exchange holdings have even decreased. Zhang Bin, a researcher at the Institute of Social Economics of the Chinese Academy of Social Sciences, pointed out that the change in the central bank’s foreign exchange reserves reflects its level of intervention in the FX market: from January 2003 to September 2011, the central bank bought an average of 207.5 billion yuan worth of foreign exchange per month. From October 2011 to August 2012, the average monthly intervention was only 10 billion yuan. This indicates a clear decline in the central bank’s intervention.
In recent months, the central bank’s purchases have been significantly lower than those of other financial institutions. In September, total financial institution FX holdings increased by 130.7 billion yuan, but the central bank’s FX account rose by only 2.04 billion yuan. In October, total financial institution FX holdings increased by 21.625 billion yuan, while the central bank’s FX account increased by only 1.084 billion yuan, half of September’s increase.
"If the central bank does not intervene, its foreign exchange reserves and base money supply won't grow, and it will rely on reverse repos to provide liquidity," said Xie Yaxuan, head of macroeconomic research at China Merchants Securities Research and Development Center.
By reducing intervention and shrinking passive base money creation while normalizing reverse repo operations to actively adjust liquidity, the People's Bank of China has clearly adopted a more independent stance since the second half of the year.
Zhang Bin believes that continuous intervention to maintain exchange rate stability in the past years has led to a large amount of base money, fueling macroeconomic overheating and inflationary pressures. Monetary authorities' use of interest rate policies has also been constrained.
The RMB is under renewed appreciation pressure. Will policymakers opt to reduce intervention and let the currency fluctuate more freely, or continue intervening as usual to maintain stability? This remains a test of their wisdom.
"A good system is hard to come by. If the talk of reforming the exchange rate formation mechanism remains just talk due to short-term considerations, then real progress will never be made. It should instill confidence in the market. In the medium to long term, market fundamentals will adjust the RMB exchange rate to a reasonable level," Zhang Bin concluded.
Currently, the central bank remains "hands-off" and refrains from intervention. However, the frequent occurrence of "upper limits" in the central parity rate has become a heavy burden for the market and could lead to a return to a dual-track system.
CICC noted that in the short term, a higher trade surplus, continuous FDI inflows, and the slow recovery of the Eurozone and US economies will make it difficult to reduce FX settlement demands. If the central bank doesn't actively purchase foreign currency, it will rely on reverse repos to increase interbank liquidity, which could keep RMB money market interest rates high. Higher interest rate differentials would further push up the RMB, hindering economic recovery and increasing societal debt burdens in the long run.
"Where the central bank goes next—whether it withstands pressure to maintain monetary policy independence or returns to the old path of intervention—remains unclear. However, regardless of whether the central bank chooses to intervene, it won't alter the basic trend of RMB appreciation in the fourth quarter," Xie Yaxuan stated.
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