Thought October 12, 2020 / 03:16 am UTC

China: Lower FX Risk Reserve Ratio following Yuan’s Surge

By Jiaxin Lu

Recent move by the People’s Bank of China (PBoC) to reduce foreign exchange risk reserve ratio will effectively help to reduce the cost of shorting Yuan, further balancing demand and supply conditions for the currency. Overall, we believe it will likely have a limited impact on Yuan, as portfolio allocation into China still remains a key theme in helping a further recovery of CNY going forward.

Figure 1: The Foreign Exchange Risk Reserve Ratio and USD/CNY 

Source: Bloomberg, Continuum Economics

The People’s Bank of China (PBoC) lowered the foreign exchange risk reserve ratio for forward foreign exchange sales from 20% to 0%, effective from October 12, following a surge in onshore Yuan last Friday. Onshore Yuan rallied to a 17-month high of 6.69 against USD on Friday, as China’s onshore market returned after a week-long holiday. Both onshore and offshore yuan pared back some earlier gains after markets opened on Monday, with both weakening by around 0.40% against USD.

The foreign exchange risk reserve ratio was introduced in 2015 (Figure 1), and was part of the PBoC’s toolbox for macro-prudential policy. This tool has been through several adjustments, especially following excessive movements in Yuan. The ratio was last adjusted in August 2018, from 0% to 20%, which helped to stem further losses in Yuan. 

Both onshore and offshore Yuan have risen sharply against USD since May, gaining by 5.1% and 6.1% respectively. We think there are several factors at play.  While the decline of USD is an important reason, the currency outlook for Yuan is also shaped by its domestic situation. For China, the domestic recovery is sufficiently good into 2021 that we now no longer forecast official interest rate cuts, which keeps the interest rate spread wide against USD. The policy move by the PBoC is seen having a limited impact on Yuan, as we believe portfolio allocation into China still remains a key theme in helping a further recovery of CNY going forward. 

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Analyst Certification
I, Jiaxin Lu, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.