The Renminbi Parity Rate and 'Countercyclical Variables'
来源:CHINA FOREX 2017 Issue 3
Foreign exchange authorities have introduced “countercyclical variables" in setting the daily central parity rate for the renminbi. This will play a positive role in smoothing out the pro-cyclical fluctuations stemming from market sentiment and cushion the impact from a herd mentality among market players. Once the new formula has been in place for a period of time, what effects will it have on market demand? How will banks adjust to the greater expectations of two-way volatility in the renminbi exchange rate and help enterprises avoid exchange rate risks? This article will try to address these issues.
Market Adjustments
Against a backdrop of supply and demand "pro-cyclicality" for the renminbi exchange rate, individuals will tend to increase their holdings of foreign assets and exporters will look to delay settlement of the foreign exchange they earn. Such behavior can magnify the foreign exchange exposure from the private sector, and in turn cause short-term disruptions and even create systemic risk. After counter-cyclical factors are added to the mid-price calculation, short-term fluctuations in the exchange rate will be more closely linked to the changes in a weighted basket of currencies. This will make it more difficult to predict short-term movements in the renminbi exchange rate. As a result, some of the irrational expectations that would ordinarily appear in the market may have a less pronounced effect on the exchange rate. Under such circumstances, companies and individuals may choose to settle their foreign exchange holdings instead of holding onto them. Such settlement could be seen as a "variable" that will help balance supply and demand in the foreign exchange market. So what corresponding market changes might we see?
With the end of one-direction expectations for the renminbi, there will be a reduction in delayed settlements of foreign exchange. Participants in China's foreign exchange market need to provide that there is an authentic underlying transaction linked to trade or investment foreign exchange dealings. These participants are mainly enterprises engaged in foreign trade. In theory, these companies do not have their own expectations of exchange market trends, they will make use of their export income by exchanging it for renminbi. But in actual practice, enterprises will adjust their settlements or purchases of foreign exchange based on their expectations of future foreign exchange rates. When expectations for the renminbi are for strengthening, exporter may hold their dollar income offshore and wait to make onshore foreign exchange purchases at the last minute. This has contributed to the delayed settlement situation we have seen in the recent past.
Based on data from last year, after the prolonged expectations for one-way movement in the renminbi, the increase in monthly demand for settlement is expected to be between US$5 billion and US$15 billion. If we also assume that half of the accumulated delayed settlements since the foreign exchange reform was announced will be carried out over the next two years, this will result in an additional US$16 billion in settlement demand each month. The combination of these two factors is enough to reverse the average monthly deficit of US$17 billion seen over the last year.
Meanwhile, the pace of securities investments has also been slowing. China's overall international balance of payments reflects a current account surplus and a capital account deficit. Enterprises can use delayed settlements and make use of their foreign exchange for foreign direct investment, mergers and acquisitions, securities investments, foreign lending, trade financing, deposits or wealth management purposes. These foreign currency holdings of enterprises or individuals belong to the "foreign exchange held in non-government hands" category but are treated as part of the nation's foreign reserves. These are more easily deployed elsewhere, however. When there is a reversal of expectations for the nation's currency, differences in investment returns will lead to changes in asset deployment. Inflows of securities investments may slow or exporters may consider using their foreign exchange offshore to make up for domestic funding gaps.
Derivative Hedging
Under current circumstances where renminbi yields are higher than those on dollar holdings, and if there is a shift in expectations for the exchange rate, the accumulated potential demand for settlement over the past two years is likely to be realized gradually. That could result in greater balance between supply and demand. In this regard, commercial banks can recommend appropriate financial derivatives to their customers to hedge against foreign exchange risk.