PBoC Attempts To Stall Outflows By Re-Imposing FX Reserve Requirement on FX Forward Sales

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Alongside the retaliatory tariffs announced by the Ministry of Commerce, the PBoC is also making an effort to backstop the economy by re-imposing a reserve requirement on FX forward sales. The reserve requirement was first implemented in September 2015 and set at 20% in a bid to alleviate strong outflow pressure at the time.

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The requirement was first applied to domestic financial institutions and then to foreign financial institutions in July 2016, as USDCNY breached 6.70. However, in September last year, the reserve requirement was reset to zero as outflow pressure subsided. The PBoC’s decision to reimpose the reserve requirement reflects the bank’s concern for outflow pressure linked to the ongoing trade war. This move only elevated investors’ concerns.

Outflows Increasing But Not As High As 2015

Although FX outflow was moderate in June, with corporate purchases of a total $14 billion in FX forwards noted (compared to the $68 billion in August 2015), it is likely that outflow has picked up since then and likely intensified over July given the escalation in trade conflict with the U.S. This view is further supported by the depreciation in CNY seen over recent weeks.

The heavy weakening pressure on CNY has likely alerted Chinese officials to the risk of a negative feedback loop, as was seen in 2015 before the reserve requirement was first implemented. Reinstating the reserve requirement will not just mechanically raise the purchase price for corporates buying FX forwards, it will also give a clear signal of Chinese officials’ desire to stem the tide of CNY weakening.

PBoC Note Pro-Cyclical Market Behaviour

In the announcement made on Friday, the PBoC said that the market is displaying signs of “pro-cyclical” behaviour and noted that authorities are still firmly committed to keeping CNY “basically stable at a reasonable and balanced level”. The language clearly reflects the PBoC’s desire to see less severe downside moves in the currency as following Governor Yi Gang last mentioning these phrases on July 3rd, CNY entered a period of stability before eventually weakening again on the back of negative data surprises.

The announcement for the CNY is a clear signal to the market and provides less room for the currency to weaken in the short-term while next week’s CNY countercyclical factor will provide further insight on the near-term intentions of the PBoC.

Comments From JP Morgan

Commenting on the moves, analysts at JP Morgan noted that the “CNY is now entering a sensitive zone, close to the previous peak of 6.96 at end 2016… If the PBoC continues to take a no intervention policy, the concerns on CNY depreciation and capital outflows will likely rise further, as the CNY depreciation expectation was the key driver of the massive outflows back in 2015 – 16.

Further intervention measures are likely, such as the reviving the counter-cyclical factor in the CNY fixing formula, or even the PBoC’s correct intervention in the FX market. Will FX reserves decline notably and capital outflow pressure resume, or CNY continue to depreciate”?

Technical Perspective

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Having broken above the bearish trend line from 2016 highs, USDCNY traded up to just shy of the 6.917 level (June 2017 high) before sellers stepped in to take prices lower. For now, focus remains on the further upside with the 2016 high of 6.96 the key objective.

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