Here's What China's Yuan Tinkering Means for the FX Market: Q&A

(Bloomberg) -- When news broke that China’s central bank was altering the way it manages the daily fixing of its currency, investors snapped to attention.

Perhaps some recalled the move that roiled markets in August 2015 -- though that swoon happened not because the People’s Bank of China introduced a new mechanism, but because it unexpectedly devalued the currency, spurring speculation China may further weaken. Tuesday’s move was more technical.

Still, Bloomberg’s report that the PBOC effectively removed the “counter-cyclical factor” in its fixing mechanism sent the yuan lower by the most in almost three months, while emerging-market currencies as a group sold off. Here’s why:

What is the yuan fixing?

The PBOC sets a reference exchange rate for the yuan on a daily basis. The yuan is allowed to fluctuate 2 percent above or below the reference rate daily, known as the fix. When the rate threatens to break the bounds, the central bank buys or sells the yuan.

How does PBOC calculate the fixing?

For a long time, the mechanism remained a mystery. Then in 2015, China revamped the system, saying the fixing was based on the previous close of the yuan against the dollar and the overnight movement of the greenback versus a basket of currencies that includes the euro and yen. In May 2017, the PBOC added the “counter-cyclical factor” as the third component in the formula.

The PBOC has never disclosed the formula for the new component, but said it was designed to offset “herd behavior” and prevent a one-way bet on the currency. By adding a discretionary element, the central bank gained more control over the fixing.

Economists at Goldman Sachs Group Inc. found that the “counter-cyclical factor” did what it was supposed to do. When the yuan weakened, the PBOC set the fixing stronger relative to the previous model, and vice versa.

Why remove it now?

The PBOC has long argued that it wants a more flexible exchange rate, aiming to make it more widely used in international trades and financial transactions. The liberalization and internationalization process has been stalled since late 2015 as the weaker yuan prompted capital outflow. Over the past two years, the authorities tightened capital controls, which helped stabilize the exchange rate.

Now that outflows have abated and the yuan has started to appreciate, from 6.9 per dollar in May to about 6.5, policy makers may see a window of opportunity to let the market play a bigger role in determining the rate. It’s a sign that the authorities are more confident that the exchange rate won’t destabilize the economy.

So why did the yuan weaken today?

In theory, removing the counter-cyclical factor means the central bank reduces its control. The change in itself won’t have much directional impact for the yuan, one way or the other.

In this instance, it may be more about the signaling effect -- after all, the last time the yuan approached 6.5 to the dollar, in early September, policy makers removed a reserve requirement that made it harder for investors to bet against the Chinese currency. The yuan indeed weakened in following weeks.

Also, against a basket of currencies, the yuan is trading near the top of the range it has held for the past 18 months. Investors may be worried that if the yuan continued to appreciate, the PBOC might take other steps to slow the pace of the yuan’s appreciation.

Why is there no broad impact for global markets?

China roiled markets in August 2015 when it reformed the fixing regime, but that was because of the surprise devaluation, the most since 1994 and at a time when the world economy was slowing. The moves spurred speculation that Beijing sought to weaken the yuan to shore up growth and start a currency war. This time, however, the tweak is more technical, the yuan has been on a upward trend, and the global economy is enjoying a synchronized recovery.

--With assistance from George Lei and Cameron Crise

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.net.

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Michael P. Regan at mregan12@bloomberg.net, Joanna Ossinger

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