China Considers Changing Yuan Fixing Formula to Curb Swings

China is considering changes to the way it calculates the yuan’s daily reference rate against the dollar, a move that’s likely to reduce exchange-rate volatility while undermining efforts to increase the role of market forces in Asia’s largest economy.

Policy makers may add a “counter-cyclical factor” to the yuan’s daily fixing, according to government statement on Friday, which confirmed an earlier report by Bloomberg News. Analysts said the change would give authorities more control over the fixing and curb the influence of market pricing.

While a more tightly-managed currency could give China breathing room to push forward with a deleveraging campaign that’s popular among Western investors, it would mark a step back from President Xi Jinping’s 2013 pledge to give markets a central role. The central bank’s existing fixing system won international plaudits for being more market-oriented and helped the yuan win inclusion into the IMF’s basket of global reserve currencies.

“The counter-cyclical adjustment factor sounds like an increased role for the fixing to be nudged away from where markets would set it,” said Sean Callow, a senior currency strategist at Westpac Banking Corp. in Sydney. “The authorities’ actions give the impression that they are more worried about yuan stability than declared in their public statements.”

Propping up the yuan has been a policy priority this year as authorities try to stem capital outflows and prevent financial shocks before an important leadership reshuffle in the ruling Communist Party at the end of 2017. The stakes have increased in recent weeks after the regulatory clampdown on leverage roiled domestic bond and equity markets.

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Under the new formula communicated to lenders by the People’s Bank of China this week, institutions that provide quotes for the fixing will add the counter-cyclical factor to their existing models, which take into account the previous day’s official closing price at 4:30 p.m. local time and changes in baskets of currencies, according to people familiar with the matter, who asked not to be identified because the matter is private. Banks are currently tweaking and testing their models and will start providing quotes using the new system soon, the people said.

China’s foreign-exchange market can be driven by irrational expectations, resulting in “unreal” supply and demand that increases the risk of overshooting, according to a statement on Chinamoney.com, which is run by China Foreign Exchange Trade System. The “counter-cyclical factor” may ease “herd actions” and help guide investors to pay more attention to economic fundamentals, according to the statement.

Central bank policy stipulates that the yuan is restricted to moves of no more than 2 percent on either side of the reference rate.

Fixing Discretion

For China’s government, the existing market-based fixing system’s downside is that it makes the exchange rate more difficult to control. The yuan’s 6.5 percent slide in 2016 created a vicious circle of capital outflows and currency weakness, prompting officials to burn through more than $300 billion of foreign-exchange reserves and introduce tighter capital controls.

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Authorities may see a new fixing formula as a cheaper way to achieve yuan stability. Officials have already used the reference rate to guide the currency higher in recent weeks, setting the fixing at levels that were consistently stronger than analysts predicted.

“The PBOC has been fixing with a major dose of discretion,” said Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong. “We can consider this ’counter-cyclical adjustment factor’ as using that discretion.”

While the yuan has fluctuated in a narrow band around 6.9 per dollar for most of this year, the currency broke out of that trading range over the past two days amid suspected government intervention. The currency strengthened 0.2 percent to 6.8586 per dollar as of 3:36 p.m. local time, heading for the biggest two-day gain since January.

By taking steps to scale back the spot market’s role in the fixing formula, authorities may undermine efforts to make the currency more freely traded, according to Tim Condon, head of Asia research at ING Groep NV in Singapore.

“The latest move is aimed at reducing volatility by damping the impact of the change in the spot rate,” he said. “If the yuan endgame is a free float like the other major currencies, refining the PBOC fixing mechanism is a retrograde step.”

— With assistance by Ran Li, Steven Yang, and Tian Chen

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