China FX Stable for Now; CNY Weakness Eyed in 2016 - Analysis

The Chinese yuan, both on-shore and off-shore have been relatively stable in the past few days, with both underpinned by intervention by the People's Bank of China and recently announced measures to stem yuan weakness.

Global investors have taken modest comfort from the FX calm seen recently, but in light of the volatility seen earlier in January, were still penciling further CNY and CNH weakness in 2016.

The CNY or on-shore yuan, closed at CNY6.5786 versus the dollar Tuesday, after trading in a CNY6.5753 to CNY6.5800 range. This compared to Monday's close of CNY6.5788.

The USDCNY high of CNY6.5962, posted Jan. 8, 2016, was the highest level seen since February 14, 2011 (CNY6.5980 high). The 2011 peak was CNY6.6369, seen January 10.

The PBOC intervened heavily January 12 to help narrow the spread between the on-shore and off-shore yuan. The first week in January, the CNH-CNY spread widened to as much as 1,400 pips, as speculators entered into CNH shorts on expectations of a higher USDCNY.

This forced the PBOC to intervene, as one of the conditions of the yuan's entry into the IMF's SDR basket was to close the gap.

The CNH-CNY spread has narrowed substantially subsequently, with the spread at roughly 139 pips at today's close.

The PBOC set the Chinese yuan central parity rate versus the dollar at 6.5596 Tuesday morning, compared with Monday's 6.5590.

The market cheered Chinese GDP data, released earlier, showing year-on-year growth at 6.8%, below MNI's median of +6.9%, but still solid enough to allay fears about a larger slowdown.

However, MNI's Nerys Avery warned that China's growth is "Not So Pretty Under The Hood." See MNI Main Wire at 7:16 a.m. ET.

On the weekend, the PBOC stepped up its management of money flowing in and out of the country, requiring yuan-denominated deposits placed on-shore by financial institutions licensed to conduct yuan business overseas to be subject to the same reserve ratio requirement (RRR) as ordinary deposits.

The rule, effective January 25, means that any onshore bank allowed to take such deposits, known as an onshore agent bank, will have to set aside a percentage of those deposits as reserves at the same rate that currently applies to most other deposits.

The ratio is a range of 17% to 17.5% for large banks and around 15.5% for smaller banks. The RRR on foreign institutions' onshore deposits was previously set at zero.

PBOC actions appear to have acted to put a cap on the CNH rate versus the dollar and in turn, help to keep the CNH-CNY spread narrow.

USDCNH was trading around CNH6.5911 Tuesday afternoon, in the middle of a CNH6.5833 to CNH6.6090 range and well down from the CNH6.7618 high seen January 7, which was the lowest CNH level seen since Sept. 2010. China allowed the yuan to be bought and sold outside the mainland earlier in 2010.

In terms of FX technicals, "the short term correction for USD/CNH continues to develop but the lift from the important 6.56/6.53 zone raises the risk of additional upside as a break above the 6.65 area suggests a better tone," said Niall O'Connor, technical analyst at JP Morgan.

A new run-up in USDCNH would likely have spillover ramifications, with scope for other Asian currencies to weaken versus the greenback in coming sessions, he said.

"Note that other USD pairs can see some additional near-term retracement as well, but the overall upside risks are intact," O'Connor said.

The PBOC's move to "normalize" the RRR for offshore financial institutions' onshore yuan deposits has altered the liquidity situation, analysts said.

While the central bank claimed in a statement that the new rule, which raised the RRR on those deposits to 17.5% from zero, would have no impact on onshore liquidity, it will effectively take out CNY200 billion from the banking system on January 25, when the increase goes into effect.

In addition to the sudden RRR requirement, other demands such as tax payments, pre-holiday cash withdrawals by individuals and companies, plus capital outflows are all adding to the pressure on interbank liquidity. Banks' use of leverage to buy bonds is exacerbating an already tight liquidity situation. See MNI Main Wire story at 7:58 a.m. ET for further details.

"The PBOC said the measure is meant to improve macroprudential regulations and restated support for the RMB internationalization," said Dariusz Kowalczyk, senior emerging market strategist at Credit Agricole CIB.

"The move's timing reflects the desire to limit on-shore-off-shore arbitrage and raise funding costs for long USD/CNH FX positions, thus supporting the CNH, he said.

Instead of speeding up the process, Chinese yuan internationalization will likely slow, he said.

"The main impact of the measure will be to withdraw funds from the CNH market permanently, which will boost long-term CNH funding costs," which means, that "FX swap points and CNH CCS rates will be significantly higher, while the USD/CNH rate will be lower," Kowalczyk explained.

One caveat however - by the end of Q116, part of the deposits of off-shore institutions kept in on-shore banks will return offshore, discouraged by the reserve requirement," he said.

Come January 25, CIBC estimated that, "a significant amount of the CNH - from CNY21bn to CNY494bn - will be transferred on-shore to meet the reserve requirement," with markets underestimating the impact of this.

CACIB looked for liquidity to tighten starting next Monday.

In a research note, Goldman Sachs strategists outlined three "takes" about the path of the Chinese yuan going forward.

"First, there is the view that the trade weighted RMB is essentially stable, with weakening only against the Dollar to offset USD strength; Second, there is a view that the RMB actually needs to fall on a trade-weighted basis, given the weak cyclical picture in China," they said.

Finally, there is a camp arguing "that China's balance of payments is out of control, with large capital outflows making a large devaluation all but inevitable, even with the high level of foreign exchange reserves," the strategists said.

Goldman saw the third scenario as unlikely, and favored a combination of the first and second scenarios.

Such a mix would be in "the spirit of our China team's revised forecast for the USDCNY fix, which they expect to be at 7.00 a year from now," which would be a 2% weakening of the yuan in trade weighted terms, the strategists said.

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