The currency's tight trading band is widening for the first time since 2014 because of the macroeconomic risks that cause unprecedented levels of volatility in China's yuan, investors are betting that authorities may widen the currency's tight trading band for the first time since 2014 to allow market forces greater say.
The currency has never moved above 1 per cent on either side of the mid-point in the eight years since the band was defined, and it is allowed to move in a narrow range of 2 per cent against the US dollar.
Foreign capital fled an economy struggling under regulatory and COVID 19 crackdowns and the PBOC seemed to let market forces decide where the yuan should be, despite the fact that it lost its languor in September as an aggressive Federal Reserve and robust dollar pushed the yuan to the weaker side of seven versus the greenback.
Becky Liu, head of China macro strategy at Standard Chartered Bank, believes that there will be a possibility of the PBOC widening the daily trading band against the dollar to 3 per cent from 2 per cent in 2023.
The day-to-day yuan volatility has gone up by 16 per cent on some days in October, compared with a tame 1 per cent to 4 per cent range in the months and years before. The currency came close to touching the weak end of the band in five out of 16 trading days in October.
Implied volatility, an options market gauge of future volatility, has spiked. An options trader said the market was long volatility One, three and six-month yuan implied volatility hit all-time highs, while nine-month and one-year tenors are at their highest levels since Beijing's currency reforms in 2015 when it engineered a 2 per cent devaluation.
In 2014, the PBOC doubled the daily trading range to 2 per cent, in an attempt to get the yuan into the IMF's currency basket, according to market participants. It was included in 2016
Policy sources told Reuters they had considered widening the trading band over the past few years to show their commitment to long-term market reforms.
Tommy Wu, senior China economist at Commerzbank, said if the PBOC wants to widen the trading band, it will likely happen in the latter part of 2023, when the economy rebounds visibly, and interest rate differentials with the US may start to shrink meaningfully to favour the renminbi.
In its latest quarterly monetary policy implementation report, the PBOC vowed to allow markets to play a decisive role in determining the exchange rate of China's yuan, which has declined around 11 per cent against the dollar this year, but global investment houses expect it to recover in 2023, according to the latest quarterly monetary policy implementation report.
The central bank doubled the trading band for the pair to 10 per cent in March due to rising volatility in yuan-rouble trading earlier this year.
Most analysts don't think it is imminent, despite the fact that a band widening is due.
Alvin Tan, head of Asia FX at RBC Capital Markets, said the band widening is unlikely to occur until it is clear that the US dollar's cyclical uptrend has peaked, and that any action could be seen as a signal of further renminbi depreciation.
The PBOC probably has to see that the Fed's rate hiking cycle has ended for sure.