China's Central Bank Is Rethinking Relations With Markets

Updated on
  • Removal of fixing curb on currency helps yuan liberalization
  • PBOC will have to walk a difficult tightrope in 2018: analyst
Bloomberg’s Emma O’Brien reports on China’s decision to make a change to the regime used to manage the yuan.

As the end of People’s Bank of China Governor Zhou Xiaochuan’s term approaches, a firmer yuan and calm markets are providing a window to get some of his long-term reforms back on track.

The latest news in the two-steps forward, one-step back move to a more freely traded currency came Tuesday, as Bloomberg reported the central bank has tweaked its management of the daily currency fixing, removing a hurdle to the influence of market forces. PBOC adviser Huang Yiping says that shows authorities’ desire to further liberalize the exchange rate.

Click here to read more on the comments from PBOC adviser Huang Yiping

The PBOC is adding transparency to its daily interactions with the money market, aiding Zhou’s long quest to move to a price-based monetary framework. The central bank is also developing tools to rein in risks in banking and property markets after vocal warnings from Zhou on the risks of inaction on these fronts.

Yet 20 years after the PBOC stopped the practice of credit quotas -- commanding who gets to borrow money in the economy -- the central bank still hasn’t completed its shift to a market-based system taken for granted in developed markets. While Zhou has pushed his institution far along that road, hints he’ll retire "soon" mean his successor will need to complete the task.

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“The Chinese economy has entered 2018 in a Goldilocks state – ‘not too hot and not too cold’. This has created a good opportunity for the PBOC to press ahead with important reforms," said Rajiv Biswas, APAC Chief Economist, at IHS Markit Ltd in Singapore. “However the PBOC will have to walk a difficult tightrope during 2018, to provide sufficient liquidity and credit growth to allow the Chinese economy to grow at a pace of around 6.5 percent."

Here are the areas in which the PBOC is advancing its reform effort:

Yuan Policy

The yuan bucked analysts’ predictions to surge 6.8 percent last year in its best performance since 2008. The advance -- a result of tighter capital controls and a weakening dollar -- has damped bearish bets, creating an opportunity for policy makers to move back toward currency liberalization.

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By relaxing constraints on the market pricing of the yuan introduced last year, policy makers are encouraging a freer currency. China introduced the so-called counter-cyclical factor in a bid to reduce volatility in the yuan, which had weakened for three straight years, triggering the introduction of capital controls.

What’s further in store may include a widening of the yuan’s trading band, which is currently 2 percent on either side of the PBOC’s daily reference rate, and relaxation of capital curbs that were put in place since a shock devaluation in 2015. Still, with the searing experience of that 2015 event still fresh in policy makers’ minds, moves may be incremental for fear sudden steps would renew pressure on capital outflows.

Rates Policy

The PBOC has invented a wide spectrum of monetary tools and conducts a complex array of operations to maintain its desired level of liquidity in the inter-bank market. It’s with these open market operations that the PBOC has responded to rate hikes by the U.S. Federal Reserve while keeping the broader benchmark rates stable since late 2015.

The central bank resumed OMOs on Wednesday after a 12-day pause.

With financial institutions relying more on the central bank’s open-market injection as the source of funding, the PBOC has the chance to construct a curve anchored on the cost of these operations. But the task is incomplete, since the central bank still needs to use quantitative measures to make sure the supply of funds to the real economy is stable.

A trusted and effective yield curve would help investors understand the price of assets in China and attract more foreign capital into the nation.

Two Pillars

The PBOC is moving to a "two-pillar" framework that pairs rates policy with a "Macro-Prudential Assessment," or tools geared to regulate prices of financial assets. Doing so can help the central bank better predict systemic risks and prevent them from materializing.

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Yet the construction of the framework is still at initial stage. While it has said that the MPA’s two essential indicators are broad credit and real estate prices, there aren’t ready-to-use methods to calibrate them, and financial innovations leave traditional statistics behind. The PBOC said it intends to cover a wider variety of financial activities in the MPA, according to the third-quarter monetary policy report released in November, but it still hasn’t elaborated what it covers already or their weighting.

— With assistance by Yinan Zhao, Tian Chen, Ran Li, Qizi Sun, Justina Lee, and Ye Xie

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