Too crowded bets on “7” for USDCNY could be dangerous

• As the Chinese yuan weakened significantly over the past few days following the US’ announcement to escalate the trade war with China, there is now a heated debate as whether it will hit “7” or, put it in another way, if “7” is an unbreakable magic number. So far, the market seems to believe that the PBoC has a floor on the USDCNY at “7”.
• Is this really the case? We do not believe so.
• Based on the net reduction in US Treasuries holdings and the use of its countercyclical factor, the PBoC seems to have conducted sizable forex intervention to keep the RMB stable. It is vital to note that China’s key concern is growth and RMB stability is increasingly important to achieve this goal but not a specific ceiling at “7”. The reason is that the fear of a substantial RMB depreciation may lead to capital outflows, which can further reduce available liquidity and, thereby, strangle growth.
• While RMB stability is important, it does not equate to targeting a number, or setting a ceiling on USDCNY. Yuan volatility against the USD has increased significantly after 2016, echoing the PBoC’s announcement to enhance the two-way volatility of its currency. In other words, the PBoC has definitely realized that any one-way betting on the CNY could only dampen its efforts to control the currency.
• This means that, although the PBoC is willing to push for the stability of the USDCNY, it would avoid wasting too many bullets to defend 7. The best strategy for the PBoC is to lean with the wind for forex intervention rather than against the wind, as the latter is clearly more costly. As such, the PBoC needs to introduce more two-way volatility. This is exactly what the PBoC did in early 2014 when it tricked the market by engineering a mini devaluation of the yuan against the USD against the background of a one-way bet for appreciation.
• All in all, while the market is likely to see the PBoC intervening in the RMB market, we do not think “7” should be considered a ceiling. The objective of RMB stability is to avoid rapid capital outflows which could shake investor’s confidence. But to that end, the problem for the PBoC is not a fear of the magic number 7 but instead too crowded trades betting on the one-way movement of the RMB. If the investors start to speculate on one number, the PBoC will do its utmost to make them pay as it did in March 2014.

Full report available for NATIXIS clients.