China Revives Currency Deposit Rule to Halt Yuan’s Slide

China will reimpose from Monday a requirement that financial institutions hold a deposit at the central bank when they purchase foreign exchange forward contracts for their clients, a move that is expected to dampen bets that the yuan will continue to fall and so arrest its recent sharp decline.

The People’s Bank of China (PBOC) will raise the foreign exchange risk reserve ratio on currency forwards to 20% from zero currently, it said in a statement posted late Friday. Because the foreign exchange market has been “volatile” recently due to factors such as rising trade tensions, the new policy is intended to “prevent macro financial risks and help financial institutions operate in a healthy and stable manner,” the statement said, referring to tit-for-tat tariffs China and the United States have imposed or threatened to levy on each other.

“Ahead, the People’s Bank will continue to strengthen the monitoring of the foreign exchange market and take effective steps to conduct counter-cyclical adjustments when necessary, to maintain the broad stability of the yuan exchange rate at a reasonable equilibrium level,” it said.

The PBOC first imposed a foreign exchange risk reserve ratio on currency forwards in October 2015 to halt the Chinese currency’s depreciation at that time. The yuan had fallen sharply following the central bank’s decision to change the mechanism used for calculating the yuan’s daily parity rate two months earlier. A currency forward is an agreement to buy or sell a currency at a fixed exchange rate on a future date, usually to hedge against market volatility.

Under the original rule, financial institutions were required to deposit 20% of the amount of their previous month’s yuan forwards in a special non-interest-bearing account at the central bank for one year. The policy was seen as an effort to crack down on speculators betting on a decline in the yuan by increasing their financing costs.

The central bank suspended the requirement in September 2017 after the Chinese currency appreciated and market expectations that the yuan would continue to decline dissipated.

The resumption of the deposit requirements comes after the yuan has weakened significantly against the dollar since mid-June amid the intensifying trade dispute between China and the United States. The depreciation accelerated from last month as the U.S. and China turned threats into actions by applying punitive tariffs on each other’s goods. Bilateral trade tensions have since escalated further, with both sides continuing to raise the stakes.

The Chinese currency lost a total of 374 pips against the greenback last week, marking its eighth straight weekly depreciation. The yuan was trading at 6.8620 against the dollar in the onshore spot market at the official market close at 4:30 p.m. Beijing time on Friday, 4,697 pips weaker than its level on June 14.

The reintroduction of the foreign exchange risk reserve ratio on currency forwards is expected to put the brakes on the rapid depreciation of the yuan by raising the costs for purchases of foreign currency, analysts said.

The offshore yuan reversed losses on Friday after the PBOC statement, climbing 0.53% to 6.8451, according to a report by Bloomberg.

“Regulators will not let (the yuan’s) exchange rate depreciate significantly without doing anything, even though their tolerance for volatility has increased,” said Wang Youxin, a researcher with the BOC Institute of Finance, adding the PBOC has other tools – including the counter-cyclical factor in the calculation of the daily yuan parity – that it can use to stabilize the yuan’s exchange rate, if necessary.

The counter-cyclical factor, introduced by the central bank in May last year, essentially gives the government more discretion to influence the currency’s daily parity, the midpoint for allowable daily volatility in the exchange rate. The PBOC now allows the yuan to fluctuate up to 2% above or below the central parity each day.

David Qu, a former staffer with the PBOC’s Financial Stability Bureau and now an analyst with ANZ bank, said the central bank’s decision to reimpose a foreign exchange risk reserve ratio rather than use the counter-cyclical factor showed that authorities are concerned over potential capital outflows more than the fluctuation of the yuan’s value.

“The foreign exchange risk reserve ratio will affect the quantity (of forward contract purchases by) companies and is more about sending a signal,” said Qu.

Contact reporter Fran Wang (fangwang@caixin.com)