How Will the PBOC Respond to the Short-Selling of RMB Exchange Rate?

It is reasonable that the capital markets rise and fall, just like the roller coaster ride which we are used to it. But the market yesterday did give us a big blow. In the daytime yesterday, the U.S. Treasury yields broke above 4%, the dollar index was closed to 115, and the USDCNH broke above 7.26. In the evening, the television conference content on China's foreign exchange market self-regulatory mechanism was spread in the market. China's central bank warned not to bet on the unilateral appreciation or depreciation of the RMB exchange rate. Then the USDCNH dived 400pips and began to reverse. Later, the Bank of England announced unlimited temporary bond purchases, stirring the market. By this morning's close, U.S. stocks, and European and U.S. government bonds surged, and the 10-year U.S. Treasury yields plunged 30bps. Crude oil, natural gas, and precious metals recorded big gains, while the U.S. dollar index hit the biggest drop in six weeks. Such a surge and plummet are enough to spark your adrenaline.

Since the RMB exchange rate reform in 2015, overseas hedge funds have been waiting for an opportunity to short the RMB for profit. On August 11, 2015, the Chinese central bank announced that it would adjust and improve the mid-price quotation mechanism of the USDCNH exchange rate, which meant the mid-price would be set by the market. Then the USDCNH mid-price of the day would be determined with reference to the closing price of the previous day and the market factors of that morning. That move was considered by the market as the PBOC would exit from the daily intervention of the USDCNH mid-price formation mechanism, so those overseas hedge funds immediately shorted the RMB exchange rate, resulting in the USDCNH rising from 6.22 in August 2015 to 6.99. And 2018 was the climax of shorting the RMB exchange rate. With the escalation of trade friction between China and the United States, those overseas hedge funds smelt the blood and found the opportunity to short RMB for profit. It caused the USDCNH to rise from 6.263 in March 2018 all the way to 7.196. This year, as the Fed has continued to raise interest rates sharply, triggering an increasingly serious inversion of the U.S.-China interest rate spread, they are back again. The USDCNH has been depreciating from 6.305 in March 2022 to 7.265. The scale of the short selling was relatively small during the exchange rate reform while it lasted longer during the trade friction. But the current short selling has a worse impact, and we cannot judge the end of this round of devaluation.

After several rounds of overseas short selling, the Chinese central bank has accumulated much experience. During the depreciation in the 2015 exchange rate reform, the PBOC directly intervened in the foreign exchange market with foreign exchange reserves to stabilize the RMB exchange rate, and withdrew the offshore RMB liquidity to raise the cost of shorting the RMB. At the same time, it repeatedly raised refinancing rates to stabilize the U.S.-China rate spread to curb capital outflow pressure. Finally, in May 2017, the PBOC formally introduced the counter-cyclical factor into the mid-price formation mechanism, ending that round of short selling. However, the direct intervention with foreign exchange reserves has little effect, and instead, it will provoke speculators to strengthen their short selling, while strengthening expectations management is more effective in curbing the "herd behavior" in the RMB foreign exchange market.

This is also the ancient wisdom of the Chinese. In the face of the pressure of sharp exchange rate depreciation, they unblock rather than block blind investments. Direct intervention is undoubtedly blocking, which is not a good method. Unblocking is to guide domestic foreign enterprises to increase foreign exchange hedging and reduce unilateral gaming. Only with good management of expectations in these enterprises, the external problems can be easy to solve. And external short-selling speculators will also feel a strong deterrent.

The short-selling was even stronger during the U.S.-China trade friction in 2018. The PBOC continuously introduced three major measures in August 2018. The first was to restart the counter-cyclical factor to make up for the "loopholes" in the RMB exchange rate pricing mechanism, reduce the pro-cyclical fluctuations in the exchange rate and control the herd behavior. The second was to raise foreign exchange reserves to reduce the shorting. And the third was to tighten the RMB liquidity in offshore markets to raise the cost of short selling for speculators.

This year, the RMB has actually undergone some internationalization changes, which have a relatively great deterrent effect on short-selling speculators. For example, the IMF increased the weight of the RMB in the SDR in May, which can attract more central banks to include the RMB in their foreign reserve assets. The extension of trading hours in the inter-bank foreign exchange market in June cut the opportunity for speculators to suppress the mid-price by taking advantage of the night trading. The launch of the Hong Kong-Mainland China interest rate swap markets in July has provided interest rate risk hedging tools for overseas investors to invest in RMB bonds and has also largely alleviated the pressure from decreased RMB bond holdings caused by the inverse U.S.-China yield spread. And of course, the increase in the RMB's share in global trade settlement is also improving the supply and demand in the RMB foreign exchange market.

The repeated pandemic in China in April and the closure of Shanghai led to a serious downturn in the Chinese economy. Moreover, the Fed's aggressive interest rate hikes caused a continued inversion of the U.S.-China spread. Foreign investors cut their holdings of Chinese bonds, which triggered this short-selling boom in the RMB and made it even more tricky. Since the effect of direct intervention in 2015 was small, and no direct intervention was made after that, it is expected that direct intervention will not be used this time. In the face of this rapid depreciation, China's central bank has adjusted the reserve requirement for foreign exchange sales and will use more flexible policy tools later. Perhaps it will mainly continue to regulate the RMB liquidity in the offshore markets, strengthen cross-border capital flow control, and introduce counter-cyclical factors, strengthening expectations management and striking precisely.