China tightens dollar liquidity to moderate yuan appreciation

The People’s Bank of China (PBOC) has implemented measures to restrict dollar liquidity in response to the yuan's continuous rise, providing a break for China's export sector. Analysts believe this move will help curb the appreciation momentum driven by the country's substantial trade surplus. In the first nine months of the year, China's goods trade surplus reached an all-time high of US$938.1 billion, up from $726.2 billion in the same period last year.

The expectation is that a larger surplus will lead to increased foreign exchange settlement volumes. Prior to the PBOC's policy, a cycle of strengthening appreciation expectations, concentrated foreign exchange settlements by exporters, and accelerated renminbi gains was occurring, negatively impacting China's exporters when converting their dollar earnings into yuan.

This created a "prisoner's dilemma" for exporters, as described by Kevin Li, a Shanghai textile product exporter. Li's firm has temporarily halted foreign exchange settlements and is waiting to see the outcome of the PBOC's measure, which will take effect on November 15. The PBOC plans to increase the reserve requirement ratio for foreign exchange deposits by 2 percentage points to 6 per cent, which is expected to lock up $24 billion of dollar liquidity.

As a result, the onshore yuan has weakened by more than 300 basis points and traded above 6.68 yuan per US dollar. For exporters like Li, whose contracts were signed last year when the onshore yuan traded above 7 yuan per US dollar, the situation is challenging. By December, Chinese exporters typically settle all outstanding supplier payments, wages, and taxes, making them particularly vulnerable to the impact of yuan appreciation.

The PBOC's intervention aims to safeguard the economy's resilience against a backdrop of dollar strength and Federal Reserve tightening. According to Citic Securities, the central bank's move seeks to prevent appreciation expectations from becoming self-reinforcing and to curb herding behavior among exporters. However, the yuan's appreciation trend is likely to continue, making the PBOC's measures a temporary reprieve for Chinese exporters.

This is the second time this year that the PBOC has taken steps to temper the yuan's rally, following the announcement at the end of February to eliminate risk reserve requirements for foreign exchange forward contracts.