The RMB Basket Composition

The basket content for the new RMB peg is revealed, and the principles and methodology for the choice and weight of the currencies, see PBC's official script for the speech at its website (English version for reference). I believe there are a few reasons for this move.

  • To avoid overzealous human error and force adherence to a mechanical peg procedure, and also to convince the mass it is not an arbitrary 'black box'
  • To facilitate the forward hedging operators
  • To convince businesses to switch contract into non-USD currencies

The estimated currency weights, according to Stephen Jen of Morgan Stanley, are illustrated in the this chart.

  • HKD is counted into the USD weight
  • It is unclear whether TWD is included, because PBC does not convert TWD into RMB directly and Jen counted it into USD weight as well because most of the transactions are denominated in USD
  • FDI and Trade (goods and service) are included in the above estimate
  • There are other currencies (e.g. THB), basically all those with trade value above $5bn will be in the basket

The current account is the basis for determining the weights (detailed definition here)

  1. Tangible goods trade (import, export)
  2. Service trade (transportation, tourism, communication, construction, insurance, IT, patent license fees, consulting. advertising, entertainment and other business and government services)
  3. FDI and related dividends (investment and salary incomes and expenses), e.g., P&G China, and also Lenovo/CNOOC's investment overseas)
  4. Current transfer (e.g. private fund movement, overseas Chinese sending to relatives)

As for how the basket peg is operated daily, not much was said. But it is expected to be consistent with my previous post -- also supported by John Williamson's paper (right click to download).

A particular point worth noting is that each currency has its own gap and it has been observed that the gaps for EUR and JPY are probably set at 1% (0.5% each way)

Ito of REITI in Japan said something in line with my previous posts. I did some calculation testing the basket content and the concluded USD has an effective weight of around 60-80% (note KRW, SGD, etc all has some USD component), or that PBC was intervening on USD while allowing EUR and JPY to drift in a much larger gap, effectively trying to influence the international cross-rates as well. Ito said, "For example, movements in the yuan-dollar rate between July 22 and July 28 can be explained to a certain extent by changes in the yen-dollar and the euro-dollar rate. Even when both the yen and euro moved in the same direction against the dollar during this period, the yuan did not fluctuate as much against the dollar as the other two currencies. Thus it can be inferred that the weights of the yen and the euro in the currency basket are quite modest. "

  • "Theoretically... it would be possible for the central rate to gradually rise, though only by a bit each day. With strong buying pressure, the yuan would reach the upper limit each day (a daily appreciation of 0.3%)...6% over one month (around 20 business days)...However, on July 26, the People's Bank of China said it was incorrect to consider this 2% revaluation as the "first step in reform," or to assume that the revaluation range would gradually be expanded. In this case, the above example of a gradual rise in the value of the yuan will not happen...if the yuan-dollar rate is used as the central rate for the following day, reference to a currency basket would be basically meaningless. If the basket were used seriously, officials would probably steer the yuan-dollar rate so that the closing rate would be close to the reference currency basket. This was the most opaque part of the central bank announcement.
  • Moving to a basket system, however, does not necessarily mean that all currencies included in the basket must be used for intervention and foreign exchange reserves. Intervention to maintain the yuan's value against the basket can be done with yen, euro, or dollars. If one assumes that the exchange rates between the yen, dollar, and euro are not affected much by Chinese intervention, whichever currency China uses for intervention, the results will be the same due to arbitrage between the three currencies.
  • the composition of foreign exchange reserves is determined to ensure liquidity and from an asset management perspective. This means the currencies in which foreign exchange reserves are held are not necessarily the same as the basket currencies. Thus, adoption of a currency basket system need not imply a shift in China's foreign reserve holdings or a sell-off of the U.S. government bonds it holds."

Here is an excerpt from Economist:

China's new currency basket is broader than most economists had expected
ON AUGUST 10th, three weeks after China abandoned its decade-old peg to the dollar and moved to a managed float of the yuan against a basket of currencies, Zhou Xiaochuan, the governor of the People's Bank of China, revealed which currencies the basket contains. This came as a surprise. Singapore, which has operated a similar system since the 1980s, has never taken such a step. However, China's openness has limits: it is keeping to itself the weights attached to each currency.
Mr Zhou said that the dollar, the yen, the euro and the South Korean won have the biggest weights, but the basket also includes the currencies of Singapore, Britain, Malaysia, Russia, Australia, Thailand and Canada. The Hong Kong and Taiwanese dollars are conspicuously absent. Even so, the basket is much broader than expected. Most analysts had bet on only the dollar, the yen and the euro.
The choice of currencies (and hence presumably the weights), said Mr Zhou, depended not only on the pattern of China's trade but also on the sources of its foreign direct investment (FDI) and the currency composition of its debt. Stephen Jen, an economist at Morgan Stanley, has had a stab at estimating the weights. Using a weighted average of China's trade and FDI, he guesses that the dollar has a weight of 43%, the yen 18% and the euro 14%. This incorporates a higher dollar weight to reflect the importance of Hong Kong and Taiwan. The Hong Kong dollar is pegged to the greenbacks and all transactions between China and Taiwan are in dollars.
It is still unclear how the system will actually operate. In theory, if the dollar falls against the other currencies, the People's Bank of China should let the yuan rise against the dollar in order to hold the overall value of the basket steady. But this is at the discretion of the central bank. However, if this regime had been introduced in January, then as the dollar rose against the other currencies the yuan would have fallen against the dollar—which would hardly have pleased America's Congress.
China also announced this week a further liberalisation of foreign-exchange trading, allowing non-banks to trade in the spot market and more banks to conduct forward trading. Currency swaps will also be introduced into the onshore market.
The reforms are aimed at making the domestic foreign-exchange market more liquid. That would allow banks and firms to hedge risks and so help them to handle uncertainty following the scrapping of the yuan's dollar peg. The central bank claims the measures will give the market a bigger role in setting the exchange rate. However, thanks to strict capital controls, the bank will retain its tight grip on the yuan.


Zhou's speech:


1 comment:

Sun Bin said...

Stephen Jen of MS confirmed with my initial calculation that the implied weight of USD is much higher (he put it at over 85%) - noting that there is probably a biase in the gap monitoring of different currencies.

He also pointed out (as in the Williamson paper) that the basket weight and the reserve weight are not neccessarily aligned.