How does the new RMB peg work?

Please tune in later as the understanding of how it works is still incomplete. As more data come in we should be able to understand the system better (brown colored = edited after the original blog is posted).
-- most recent update Aug 4th, 2005.

According to Oriental Daily in HK:

This is how I believe the basket peg works. (China's new system may have some twist in implmentation, to ensure continuity, which I will explain later)
  • There will be a basket of currency, maybe around a dozen, including USD, EUR, JPY, HKD, GBP, plus currency of China's other major trading partners.
  • USD will still occupy over 50% of the weight in the new basket, but its weight may be reduced gradually in future ("Cross the River Stone by Stone" (摸着石头过河) ) -- more likely 70%-80% for USD and HKD combined (THB was 88% effectively linked to USD in 1997)
  • Every now and then (maybe daily, hourly or in real time) a new central parity ("medium value" in the gap/band) will be recalculated. Then the trading range will be monitored and controlled at +/- 0.15% around this medium value for USD, with different ranges for other currencies (perhaps 0.5-1% for EUR and JPY). If necessary, PBC will intervene to contain the trading range to within the gap
  • Every evening the closing price will be announced, in theory this will be within range of the the gaps for each currency. PBC said it will use this closing price as the central parity for the next trading day.
  • The precise combination of the basket (or the formula) is not disclosed, as PBC retains the control to adjust or change the basket mix on extreme circumstances (PBC also stressed they only 'reference' a basket formula and they have the discretion to not follow strictly the formula -- see below for discussion)
  • Let's look at a simple example, by assuming the basket is 70% USD, 30% EUR.
  • On July 22 (as announced on July 21 evening), the rate is 1USD=8.11RMB and 1EUR=9.81Rmb (because 1EUR=1.21USD), to get 8.11RMB you need to give PBC USD0.70 and EUR0.30/1.21
  • During the day USD/RMB is allowed to trade at 8.11 +/- 0.012; EUR/RMB at 9.81, and maybe +/- 0.05 -- note the gap for EUR may be larger than 0.3% ("The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of of 0.3 percent around the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China"), we observed from 7/22-8/3 that the EUR and JPY gap to be about 0.5%
  • Recalcuation: PBC will take the spot price of USD and EUR, e.g. if EUR/USD=1.19, then the new central parity for USD/RMB will become 8.11x70%+9.81*/1.19*30%=8.15, new EUR/RMB central parity = 8.15*1.19=9.70
  • The adjusted gap on July 22 will be (roughly) 0.3% from these magic numbers for USD, and maybe 0.5% for JPY and EUR
  • During day trade, PBC will defend the x-rate to the gap (e.g., +/- 0.15% for USD)
  • I would expect China to follow the formula rather strictly. (i.e. the mix of the basket, what spot price to use in the daily recalculation) The fact that they keep the basket content as a mystery (and said they will only "reference" the formula) is just a way to deter speculators away
  • Note that in a basket peg the recalculation is a totally independent concept from the 0.3% gap and one should not confused the two. e.g. the daily adjustment/change can be 3% away from yesterday if that is what the market says (e.g., if USD depreciates vs EUR by 7%, and USD weight is 70%(USD weight):30%(EUR/non USD). then the daily adjustment is 7%/70%x30%=3% so that the basket weighted average is unchanged.)
  • However, the basket content (weight and currency) and the width of each gap will be adjusted periodically. The fact that an adjustment has been done should be announced (Singapore announced the adjustment every 6 months, China is probably still trying to find what would be a suitable relaxation time)
  • People also talk about the "crawl". i.e. When the closing price is assymetrically drifted away from the central parity (because there is a gap), the central parity in the next trading day 'crawls' away from that of the previous day. e.g. if there is a general push for RMB to appreciate, PBC can choose to intervene on USD to keep it in a narrower gap while letting other currencies drift further away (but still within the gap).
  • PBC said "2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day." Businessweek interprets this statement as "China says each day it will choose one currency from the basket to be the reference currency -- but it apparently won't say which one". (Note in the Chinese announcement it seems to imply the XR for all currencies would be published, literally it means "the closing price the USD and other foreign currencies").
  • Last note, it should be very straightforward to calculate the basket composition based on the spot rate and the daily announcement. But due to the gap at the anounced closng prices, the error will be about the size of the gaps. If there is indeed a systematic crawl, the regression analysis is made very difficult and even impossible
  • In theory, if there are 12 currencies in the basket, one only needs 12 days of data to solve the simultaneous equation of 12 variables (In fact, there are only 11 degrees of freedoms). i.e., provided we know which 12 currencies are used and the spot price is different enough over these 12 data points (linear independence)
  • In practice, one should use multi-variable regressional analysis
  • It is not difficult to guess what currencies are used (there are only 200 currencies in this world and only about 20 relevant one in this case, many are pegged (therefore, not linear independent) to some major currencies
  • Note the fact that each currency has a different gap means China will be able to influence the cross exchange rate of other currencies

Some additional information I obtained recently, which enabled me to update this post:

  • (Edited to add Jul/23) The above is how an ideal system works. However, there is the problem of continuity. The opening price (central parity) tomorrow may be significantly different from the closing price today. Today (7/22 Friday) PBC announced the central parity for Monday using the word "closing price"(人民币汇率交易收盘价). So it seems they are monitoring the basket central parity during the day, in real time (instead of at end of the trading day as described above). This way the closing price of the day is already within the gap of monitoring, but it is not neccessarily the new central parity. We can at best say the "closing price" is within gap (0.3% error) of the new central parity. It adds a lot more uncertainty when one wants to use regressional to reverse engineer the basket content, and deems speculation effort on this line impractical. -- we will have more insights as more data flow in.
  • (Edited to add Jul/27) Fang Xinghai's "Appreciation Has Its Limit" in WSJ July/27 A12 said (1) a periodic adjustment (of the peg and inside the basket are "critical feature of the new regime") (2) "0.3% against the dollar and ... by even more against the euro and yen" -- seems this is where the crawl mechanism is implemented

Below are the official announcement and the Q&A by PBC. A few points worth noting (english version here)

  • 人民币汇率改革必须坚持主动性、可控性和渐进性的原则
  • 3 principle for this (and future) reform in RMB forex: activeness/preemptiveness (we determine what/when/how ourselves); control (ability to withstand extreme volatitility); progressiveness ("cross the river stone by stone")
  • 中国人民银行将根据市场发育状况和经济金融形势,适时调整汇率浮动区间
  • PBC will adjust the 'region of float' based on market needs. The translation of "region of float" could be the medium value (central parity) announced every evening, it could also mean the 0.3% gap. Literally it translates more closely to the gap. => He Fan's comments that there may be another "baby step": widening the trading band from 0.3% to say 0.5% or 1% in future.
  • However, under this system, there is a limit on how large the gap is, otherwise if EUR/USD rate changes a lot during the trading day, people can exchange USD for EUR before converting into RMB (arbitrage)
  • 参考一篮子货币进行调节 ("The People's Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies")
  • PBC said it will "Adjust next day's rate by referencing a basket of currency", it did not commit to strictly follow the formula. Although I believe they would still follow the formula very closely. Question is: Would a regular random departure from the formula does any good for PBC?

see also(in Chinese): http://finance.sina.com.cn/roll/20050721/1905220622.shtml


PBC Q&A session: http://finance.sina.com.cn/g/20050721/20151822825.shtml

english version now available here




Sun Bin said...


compare to Singapore's board. the difference is actually quite small.

both have a black box of undisclosed basket.

RMB has a narrow band of 0.3%, SGD has an undisclosed band

SQD is freely floated, central bank may intervene is it is out of bound. RMB rate is announced daily.

Sun Bin said...

Some people said it will be a 'crawl' of max 0.3% (in fact 0.15%) per day, if the basket recalculations requires a change larger that that number. It makes no sense. The central parity will then be predictable and it will attract more speculators. PBC will lose tons of RMB.

The central parity should only be dictated by market force during the past 24 hours. i.e. the relative shift within the basket.

Sun Bin said...

Stephen L Jen of Morgan Stanley said,

"The basket is much more important than the revaluation. By adopting a basket reference framework, the determinants of USD/RMB are no longer the Chinese economic fundamentals, but other currencies in the basket. Because this is a basket reference rate, USD/RMB can go either higher or lower, depending on the underlying anchor currencies. (If EUR/USD sells off, it is possible USD/RMB trades higher than the original parity of 8.28!) The basket is likely to be heavily dominated by the USD. Using China’s trade weights, normalized, a five currency basket would have the following weights: USD (27%), JPY (31%), HKD (24%), EUR (15%), and GBP (4%). The hard dollar pegs (USD and HKD) account for close to 50% of the basket. If you consider the JPY as a soft USD peg, the weight on the dollar could be as high as 80%. This means USD/RMB will still be very ‘docile’, with the index being ‘sticky’ relative to the USD."

-- that agrees with my interpretation of the basket peg.