W-Street. Freeing Yuan from its daily fix

The People’s Bank of China unexpectedly weakened its daily fixing for Chinese yuan (CNY) by 1.9 per cent on Tuesday against the USD. In an official statement, the PBC said that starting from August 11, the daily fixing will reference the previous day’s market closing rate as well as the daily FX demand and supply.

According to the PBC, this move is to increase the relevance of the daily fixing (which has stayed almost like a straight line in recent months), making it more reflective of market forces. Market has exerted persistent downward pressures on the CNY against the backdrop of weak Chinese growth, expected US Fed move and depreciation of major EM currencies against the US dollar.

Against the backdrop of the recent informal SDR discussion at the IMF, Tuesday’s move is likely intended to improve the “market-driven” quality of the PBC daily fix, so that it can qualify to be used by the IMF as a SDR reference rate. Going forward, the PBC said it will continue to increase the “marketisation” of the renminbi (RMB) RMB exchange rate, open up the FX market further. Looking ahead, against the current depreciation pressures, if the PBC was to closely follow the previous day’s closing in setting the daily fixing rate, RMB depreciation expectations could quickly become entrenched and the CNY could depreciate quite quickly and significantly in the coming days. If so, that would be a sea change in China's exchange rate policy — letting the market drive down the CNY, which can help support growth and fight deflationary pressure.

However, we think it unlikely that the Chinese government will let only market momentum drive the RMB exchange rate from now on, as that can be quite destabilising. We think the government may still want to take a relatively cautious approach on the exchange rate front. The upcoming SDR review is one consideration, and avoiding destabilising depreciation expectations and capital outflows would be a more important one. In this context, how China sets its daily fixing and manages FX market flows in the next few days will be very telling.

Nevertheless, we do see Tuesday’s move an important change in China’s way of managing the exchange rate. Given prevailing market pressures led by expected Fed rate normalisation, the RMB’s significant appreciation against other major currencies in the recent past, China’s disappointing export performance, and mounting deflationary pressures, we think the move signals a new government willingness to let the CNY slide more against the USD than previously. We now expect USDCNY trading at about 6.5 by end 2015E instead of 6.3 as previously envisaged, and 6.6 at end 2016E.