China tweaks the fix

CFETS announces intent to introduce a countercyclical adjustment factor to the USD/CNY pricing mechanism

fixer-upper
Adjustment factor: "The fix has moved away from being market-determined and towards becoming a tool for the authorities to guide the market” – Khoon Goh

The People’s Bank of China (PBoC) has said it plans to change the way it calculates the yuan’s daily fix, in its latest effort to stabilise its currency against excessive market volatility.

The China Foreign Exchange Trade System (CFETS), the trading entity run by the PBoC, announced on May 26 that it is thinking of introducing a “countercyclical adjustment factor” to the pricing mechanism of the USD/CNY fixing.

Since April, foreign exchange analysts have noticed a growing divergence between the fixing rates published by the PBoC every morning and calculations based on the central parity exchange rate formation mechanism. This shift had them wondering whether the central bank was trying to modify the way the fixing is set.

CFETS said changes to the mechanism are part of its efforts to create a more transparent, market-oriented exchange rate. It also stressed how the proposed change should guide the market to pay more attention to the country’s macroeconomic fundamentals.

“The countercyclical adjustment factor will be able to smooth excessive intraday volatility in USD/CNY spot, curbing speculation about one-way yuan movements and undermining the role of [the] USD/CNY closing price at 4:30pm,” says Qi Gao, an FX strategist for emerging markets at Scotiabank.

“Moreover, the countercyclical adjustment factor may have been added as the central bank has continuously set its daily reference rate lower than market consensus and our own forecasts since early April,” he adds.

While analysts say the new methodology could drastically reduce speculative action from participants in offshore markets, they warn the influence of the official closing spot rate will also be reduced, making the fixing less predictable and transparent.

It is not at all clear how the countercyclical adjustment factor is determined. In our view, while there will be less volatility under the proposed new fixing mechanism, it is also less transparent
Khoon Goh, ANZ

“No longer will the 4:30pm spot rate be an anchor for the next day’s fixing. There is uncertainty over how much impact the movements in the basket of currencies will have any more as well,” says Khoon Goh, head of Asia research at ANZ.

“Importantly, it is not at all clear how the countercyclical adjustment factor is determined. In our view, while there will be less volatility under the proposed new fixing mechanism, it is also less transparent,” he adds.

There is a lack of clarity on how the countercyclical adjustment factor will be determined, and CFETS’s failure to indicate whether it will be a constant number signals the Chinese authorities’ reluctance to let the yuan be determined by the market.

“The [adjustment factor] gives the authorities the ability to surprise the market and set the fix where it chooses. In that sense, the fix has moved away from being market-determined and towards becoming a tool for the authorities to guide the market,” says Goh.

Ever-changing formation mechanism

The yuan-fixing mechanism has undergone several changes over the last two years. In August 2015, the PBoC announced it would change the formation of the currency’s central parity rate against the US dollar by taking into consideration the previous day’s closing rate in interbank markets.

In January 2016, China’s authorities introduced a composite index that compared the previous day’s onshore closing spot rate with the average value of 13 other currencies weighted to the trade volume on the mainland.

In January this year, CFETS expanded the number of currencies included in the basket to 24, allowing a higher number of emerging market currencies to influence the daily fix. The following month it shortened the timeframe during which the movement of the basket is calculated, from 24 to 15 hours, between 4:30pm the previous trading day until 7:30am.

“Apart from the brief period between January [and] February 2016, the fixings have closely aligned to the onshore spot level and the fixing mechanism has been predictable. But this started to change from early April, when we noticed the fixings have been coming in stronger than our model predictions,” says Goh.

“We did not make much of it then, for we thought the stronger fixings were due to the Xi-Trump summit and that the divergence would cease soon after. But the stronger fixing bias not only persisted, but has grown larger since mid-May,” he adds. 

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