China’s Central Bank started using the “Counter Cyclical Coefficient” (CCC) to adjust CNY central parity pricing, again. The PBoC announced on its official website on August 24 (Friday evening) that they have once again started using the CCC to adjust the CNY central parity formula more actively since August. The CNH traded notably stronger shortly after the announcement, appreciating 700-800 pips to ~6.80 in the overnight session. The announcement is in line with our observation that more recently, the CNY central parity fixing started to deviated from vs. the forecast value using only the previous day’s closing price and the CFTES basket movement, suggesting that the CCC has been used to move CNY/USD fixing to the strong side. This is the second time that the PBoC has made the similar announcement – as we recall, the Central Bank first introduced the concept of using CCC to fine-tune CNY central parity pricing bank in May 2017, while in the same statement, the PBoC admitted to having been incorporating the CCC in CNY formula for a few weeks already. According to our observation, the “fine-tuning” effort was muted between January 2018 and July 2018.

In our view, re-incorporating the CCC to move CNY fixing to the strong side indicates the Central Bank’s growing reluctance for CNY to depreciate at a rapid pace. The CNY depreciated 7.1% vs. the USD and 5.1% vs. the CFTES trade-weighted basket in the past 2 months or so (since June 14 2018), driven by various factors that shifted the short-term supply-demand dynamics of the Yuan, but was reflective of the market’s deteriorated expectations on China’s growth and reflationary trajectories YTD. It is worth noting that the macro backdrop of adding CCC this time round is rather different from that of 2Q2017. Back then, CNY continued to carry on the “momentum” of depreciation even when the economy was clearly reflating, with nominal GDP accelerating from 6.9% YoY in 1Q2016 to 11.7% YoY in 1Q2017, PPI at >7% in 1Q2017, and the central bank having already hiked the OMO rates 20bp in the preceding quarter. However, continued depreciation of the CNY went against the economic fundamentals and loosened financial conditions when the Central bank’s intention was clearly to withdraw from stimulus – in this sense, the “Counter Cyclical” Coefficient was more true to its name back then. By contrast, the nominal growth in China slowed to 9.8% YoY in 2Q2018 already, resulting from the drastic tightening of financial conditions since 4Q2017. Therefore, the intention of incorporating the CCC more actively this time round was likely focused on backstopping the rapid CNY depreciation and a potential “negative” feedback loop should it trigger FX outflows -- so far, we are yet to observe any definitive signs of FX outflow.

In the near term, it is clear to us that the Central Bank’s “policy” adjustment has stepped up as USD/CNY approached 6.90. Therefore, the resistance for continued rapid CNY depreciation has increased substantially. The central bank has become more vocal in stabilizing CNY expectation since July, and had made multiple policy “tweaks” towards the same direction as CNY continued to slide. More specifically, the central bank boosted the CNY by verbal intervention on July 3, re-introduced 20% RRR on FX forward sales by financial institutions on August 3; while shortly after, FX transaction in the Shanghai free trade zone has been tightened, and etc. Meanwhile, we have observed multiple occasions where there may have been short spurs of CNH/CNY market intervention on a smaller scale. More recently, the “squeeze up” of the USD amidst rising Brexit and EM related market volatilities exacerbated the downward pressure on CNY exchange rate. Re-incorporating the CCC more actively is another policy tool to stabilize the CNY exchange rate and anchor the FX expectations, it also indicated the Central Bank’s uneasiness with the implied annualized pace of CNY depreciation since mid-June. Given our understanding of the PBoC’s “policy arsenal” and market credibility, the resistance for CNY to continue with relatively speedy depreciation has increased substantially.

Over the medium-long term, the ultimate support for CNY exchange rate lies in improved investment efficiency and lower investment risk premium in China. In our view, the policy tweaks will likely help shift the short-term dynamics more favor of CNY exchange rate supply-demand and keep short-seller at bay, however, as we have repeated discussed in our previous research, longer-term strength of the currency is underpinned by the perceived investment returns and investment risk premium for a large continental economy like China. In this regard, the more sustainable approach for supporting the exchange rate over the long term lies in stabilized growth expectations, as well as continued market-oriented reforms to improve the efficiency, transparency, and predictability of business conduct in China.