SHANGHAI Changes in the way China's central bank is managing the yuan's exchange rate have traders speculating that regulators are readying the market for another round of reform, but Beijing is unlikely to move until plummeting Asian currencies stabilise.
Traders in China's currency market say the People's Bank of China (PBOC) has tweaked its forex management strategy in recent weeks, which they say suggests the bank is preparing for the next round of liberalisation, specifically introducing more two-way volatility -- and by extension more risk --into the market.
Beijing widened the yuan's trading band in April 2012, allowing the exchange rate to rise or fall 1 percent away from the midpoint fixing on any given day.
But for much of that time the result was the opposite of volatile: the rate often glued itself to the top end of the band for weeks on end as companies speculated on even more appreciation to come.
This meant that the midpoint was less a guidance rate reflecting average market consensus than a policy leash.
This is the opposite of what reformers want, and so traders say the PBOC now has taken a two-pronged approach.
On one hand, it has set the midpoint at repeated highs, culminating in a record 6.1554 per dollar at the market open on Monday. The midpoint was fixed at 6.1557 on Wednesday, only three pips weaker than its record.
On the other, traders say the PBOC is quietly intervening through intermediary state-owned banks to keep the spot yuan in a narrow range around 6.1200. Spot yuan changed hands between 6.1207 and 6.1212 in early Wednesday trade.
"The PBOC appears to have adopted a new tactic," said a trader at a Chinese commercial bank in Shanghai.
"A stronger midpoint narrows the gap between the midpoint and the spot price, making it possible for the yuan to fluctuate more widely in the future and thus paving the way for another widening of the yuan/dollar trading band."
Economists focused on the Chinese forex market have repeatedly argued that Beijing needs to open a space for more two-way volatility by bringing the midpoint and the traded rate closer together.
As a result of the recent change, the spot rate is trading around 0.5 percent stronger than the midpoint in recent weeks, compared to the 0.9 percent-plus premium it traded at for weeks at the height of recent rallies. GRAPHIC: link.reuters.com/qyx74t
More volatility means making corporates and banks take on more risk in the forex market instead of viewing it as a way to place low-risk, one-way bets. This need was put in sharp focus in the spring of 2013, when speculation on yuan appreciation grew so rampant that cross-border rate arbitrage distorted trade figures.
DEALING WITH THE NEIGHBORS
In the near term, of course, intervening in the market is not adding volatility but rather suppressing the rise of the currency and damping expectations that another round of can't-lose appreciation is in the offing.
Onshore benchmark one-year yuan/dollar implied volatilities have been slowly headed back toward a trough hit in March, now trading at their lowest since late May.
This may also be a reaction by regulators to domestic criticism that the yuan's current strength versus other Asian currencies has damaged China's export competitiveness even while the country's economic recovery remains wobbly.
The potential for further fund outflows from China's trade-reliant Asian rivals is another wild card which traders say is making the central bank cautious.
Most Asian currencies apart from the yuan have retreated in recent months amid fears that the U.S. central bank will begin slowing down monetary stimulus. The Federal Reserve is widely expected to make that decision later on Wednesday.
Another sharp sell-off like that which roiled emerging markets in spring is not seen as likely if the Fed stimulus reduction is modest, but emerging currencies may remain vulnerable if the firmer trend in the dollar holds.
"Generally weakening Asian currencies this year appears to have delayed China's yuan reforms," said a dealer at a European bank in Shanghai.
"The PBOC signalled it would tolerate a stronger yuan by permitting the spot price to appreciate in April and May, but it now appears the market is at a crossroads given domestic resistance to more rises amid falls in other Asian currencies."
The yuan has gained 1.8 percent so far this year. The bulk of its gains, or about 1.5 percent, was recorded in April and May.
(Editing by Kim Coghill)