China has removed the "counter-cyclical factor" from its daily calculation of the yuan (CNY) fixing, according to newswire reports. Last May it introduced the counter-cyclical factor to reduce CNY volatility and counteract what the central bank considered a "herd mentality" of CNY bearish sentiment, which exacerbated capital outflows.
The measure was broadly successful: the yuan strengthened last year (its first annual appreciation in four years), and foreign exchange reserves are growing (in December they rose for the 11th month in a row, to USD 3.14tn). But we do not expect the currency change to lead to significantly higher volatility:
- It would appear that, amid a modest slowdown in the Chinese economy, the People's Bank of China (PBoC) may be unwilling to allow USDCNY to fall further below 6.50. It would be the second instance in the past six months of it trying to prevent the pairing from doing so. In September, when USDCNY plunged as low as 6.439, the PBoC made it cheaper for markets to short the CNY.
- One-month implied CNY volatility barely reacted to the news (up to 4.15% from 3.91%), and remains below levels seen as recently as last week.
- The credible threat that China's authorities could bring back a similar fixing mechanism is likely to deter significant currency speculation.
Yet the removal of the measure does make it likely that the currency will weaken modestly on a trade-weighted basis. Our current USDCNY forecasts stand at 6.50 over three, six and 12 months versus 6.52 currently, implying a 1% depreciation in trade-weighted basis this year.
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