Daily CNY Trading Band Increase: Progressing Towards Capital Account Liberalization

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

The People's Bank of China (PBOC) announced the long-expected widening of the USD/CNY daily trading band to +/- 1percent from +/- 0.5 percent effective on April 16.This move is a significant step towards a more freely traded RMB.Though history indicates that USD/CNY would probably not trade at the new maximum trading band, widening the trading band will allow the USD/CNY exchange rates to be determined more by market forces creating rate fluctuations. This aligns with China's goal of capital account liberalization and gradual loosening of FX policy.  To have a freely traded CNY market, China's financial system needs to learn to live with higher CNY volatility, allowing market forces to influence the value of its currency, similar to the currencies of its trading partners.

Accommodating market forces in the widened daily trading band would induce two-way volatilities, meaning CNY could depreciate against the USD if China poses growth or financial risks.The move reflects the authorities' belief that the CNY exchange rate is probably approaching its "equilibrium level," after appreciating almost 24 percent since 2005 when PBOC moved CNY from a USD peg to a managed floating rate regime.Indeed, recent data do not support further CNY appreciation.  China's current account surplus has fallen from over 14 percent of GDP in 2007 to around 3% in 2011.A rare trade deficit was reported in February. Last week, China reported that export and import growth in April were surprisingly weaker than expected, supporting recent Chinese rhetoric that the RMB is well valued right now.Annual import growth in April was just 0.3 percent, far below forecasts of an 11 percent increase, while exports managed growth of just 4.9 percent versus expectations of 8.5 percent.GDP growth dropped to a near three year low of 8.1 percent in Q1 this year.

While the U.S. politicians may still ask China to have a faster pace of RMB appreciation, U.S. officials seem to have shifted away from this topic to other issues such as intellectual property rights and policy towards foreign investments. Because both governments will go through some form of political transition this year, the focus will likely be on maintaining effective working relationships to promote mutual growth and financial stability. As a result, Beijing is showing little sign of heeding calls to move any faster on its currency appreciation.

The argument for one-way CNY appreciation directional play is now weakened, at least for this year. For FY 2012, we expect the CNY to appreciate around 1.5 percent by year end. USD/CNY will likely remain in a tight range around 6.30 for the rest of H1 2012.  The appreciation pace will pick up during the second half of the year as export growth recovers, capital inflow increases and the U.S. election enters the final stage.

Why does PBOC allow two-way flexibility in the CNY rate?

Widening the RMB trading band is in line with the broader goal of capital account liberalization and the gradual loosening of foreign exchange policy.This theme gained momentum in recent months when Premier Wen said in March that China would intensify reforms of its currency and "China will let the RMB move more widely," while the PBOC Governor said conditions were ripe for the RMB's exchange rate to float more widely. China seems to be quite confident that CNY has gained to an "equilibrium level" based on the trend of reduced trade surplus.Fewer surpluses mean an easing in capital inflows, less need for PBOC to drain liquidity from the market and a slower pace of reserve accumulation.

The PBOC has seized this opportunity of slower capital inflows to advance its monetary policy independence and promote more effective domestic policy to boost domestic consumption. After the global financial crisis, China began withdrawing its reliance on export and promoting greater domestic spending.  Since then, the PBOC has made itself a supplier of liquidity, reversing the trend to drain money from the market all the time. Coupled with the control over reserve requirement ratio for banks, China currently has more tools at its discretion to signal its position on market rate expectation and provide guidance on interbank bank interest rates.All these market operations have become more effective as the central bank loosens its grip on the CNY rate. Without the need to "sterilize" or drain CNY released by its FX intervention, the PBOC now has free hands to implement an effective monetary policy and influence interest rates, a key mechanism to direct a domestic driven economy. Thus, the PBOC's increased repo market action is a turning point towards guiding interest rate expectations in a manner similar to the way the Federal Reserve and other central banks in mature economies signal their rate intentions in their open market operations.

Towards a More Open Capital Account

A PBOC paper in February outlined a three-step currency reform process: easing curbs on outbound investment over one to three years, relaxing controls on loans for foreign trade, and then opening its real estate, stock and bond markets in the next decade.  Greater RMB flexibility is a prerequisite for further opening up of China's capital account that would require China lifting restrictions on cross border capital flows.

Regulatory changes in the past few months had already encouraged capital outflows and inflows.  On April 3, the quota for Qualified Foreign Institutional Investors was increased to US$80 billion from US$50 billion.On March 28, China launched the pilot Wenzhou financial reform experiment zone in Zhejiang province, allowing local residents to make direct overseas portfolio investments on a trial basis.The plan borrows from the special economic zones with which Shenzhen and other coastal cities were transformed into manufacturing hubs.  The longer-term policy consideration with capital is that it cannot easily be locked down in one place, unlike goods and people. The slow drip of financial liberalization could one day give way to a flood.China's currency market needs to become more mature to accommodate such activity.

Growth in CNH Offshore Market Helps China's Financial Reform

The government's moves to internationalize the RMB by opening up offshore CNH trading centers for the Chinese currency in Hong Kong and in other financial centers, and by facilitating foreign trade invoicing in RMB, have gradually helped prepared China to open up its capital account.

As the CNH market grows, it broadens the offshore investment opportunities for some onshore investors.That, in turn, reduces the pool of available savings for domestic banks and forces them to offer more attractive rates to retain funds onshore. Interest rates could rise in a few years because of these pressures. But that will help improve the allocation of capital to more productive sectors of the economy and foster consumer spending growth that the policymakers desire.

Implications on CNY and Other Currencies

As a more flexible CNY will reduce reserve accumulation by the PBOC, the demand for reserve currencies will be weakened.Among the major currencies, EUR will have the most to lose. Demand for the single currency has already been affected by the worsening sovereign debt crisis, and further complicated by the election results in France and Greece. As China gradually loosens its control on CNY via two-way trading, the requirement to purchase EUR to meet its reserve benchmark will also decline.

With an extended trading band, the daily trading range in USD/CNY should widen.  Volatilities in Asian currencies should increase as their trade-weighted exposure to China is high.  And as the CNY exchange rate becomes more flexible in the coming years, China and Asia will become less correlated to the U.S. economy and U.S. monetary policy.The CNY and other Asian currencies would probably move independently from other major industrial blocks.

As for the USD/CNY (currently around 6.31), although year-to-date CNY appreciation had slowed compared to previous quarters amid official rhetoric of its currency reaching equilibrium levels, CNY gains would remain compelling going into H2 and 2013. CNY should appreciate 1.5 percent for FY 2012 and reach 6.20 by Q4.  In the short term, economic uncertainty at home, combined with political and economic instability in the euro zone, could hamper positive outlook of the RMB during the first half of this year. However, China's economy is poised for an upward turn.  China's manufacturing data improved in April. "Urban and rural per capita income has been increasing faster than GDP so far, which would support consumption growth in a low inflation environment," according to Citibank.  Analysts in a Reuters poll forecast that China can achieve 8.3 percent GDP growth year-on-year in Q2 and 8.4 percent for full year 2012.Compared to the mature economies, China's growth rate is still very respectable and should encourage continued investments into China, causing further CNY appreciation in the coming years.