Phat Dragon's Take On More Chinese Yuan Volatility

Getty/Quinn Rooney

China has widened the trading band of the Yuan from 1% to 2% effective immediately.

In stock terms a 2% trading band wouldn’t mean much. But 2% for a currency that has been quite tightly-controlled by the PBOC over many years is both a big step toward liberalisation, and also a signal that the authorities have had enough of speculators making one way bets on the USD/CNY rate, and the distortions it has caused in Chinese trade data.

Westpac’s China watcher Phat Dragon believes this reform is “much overdue”.

Phat Dragon takes the view the change is another step along the road to aligning Chinese Policy with the needs of the Chinese Economy.

Phat Dragon highlights the benefits in a long quote of something he wrote back in 2007 – it is a long quote but it was both prescient back then, and still relevant now.

Once China commits fully to the pursuit of a consumer-driven economic structure, the current mix of policy parameters will be discarded rationally.

The present mix of parameters is consistent with the development model that has characterised the economy in the reform era. The maturation and exhaustion of this strategy will signal a new approach to monetary policy and international financial arrangements. The emphasis will shift from an external anchor—the fixed exchange rate—to levers controlling internal liquidity.

On the exchange rate regime itself, the appreciation trajectory of the renminbi since the revaluation has been managed so tightly that firms have chosen to eschew hedging activity. Turnover is likely to be relatively suppressed until the imperative to hedge rises. The very gradual appreciation of the renminbi observed so far has not been sufficient to convince firms that the costs of hedging are less than those of not doing so. Given this reality, the administration could decide that greater appreciation and associated volatility are a necessary evil on the way to building a developed foreign exchange market.

The basic conclusion is that FX turnover—which is currently exceptionally low in absolute and relative terms—will expand [only] with increasing symmetry in the capital control regime and increased volatility in the US dollar–renminbi exchange rate.

So there you have it. Just like the RBA back in 1983, part of this move by the Chinese is to free up internal monetary policy. But equally this move is, as officials have said lately, to put some two way flow into the USDCNY and CNH rates.

This is what is driving policy in China right now – it is also behind the reform agenda of Premier Li and President Xi as they seek to set the Chinese economy onto a long term sustainable and consumer driven growth path.

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