News that China doubled its currency band (to 2% from 1% in relation to its daily mid point) will have reverberations across markets but the reality is that China has been building up to this for several weeks and now that it has happened there may be little incentive to push for more currency weakness.
The net result will probably be less volatility after an initial knee jerk reaction and some relief in markets that the China has actually gone ahead with the move after so much speculation. The reaction of the CNY is set to follow the same script as April 2012, with volatility set to ease once the initial reaction fades.
The weakness in the CNY had been engineered to incite more two way risk to a currency that for many months had been on a one way path of appreciation. China had been forcing the CNY weaker over recent weeks in order to deter speculators who had taken significant long positions in the currency playing for further currency strength.
CNY depreciation versus the USD (around 1.5%) since mid February may also have been a reflection of weaker economic data, with China releasing a series of data releases that had missed consensus forecasts, especially recent trade data.
Already both implied and realized USD/CNY volatility has been trading well in excess of past moves (as reflected in statistical significant readings in our Z-score analysis). Additionally risk reversal skews (3 month, 25 delta) have been flirting with its 2 standard deviation band indicative of the view that the options market holds an extreme view of CNY downside risks.
The main imponderable is what China does now. The band widening is clearly a further step along the road of freeing up the currency on the road to capital account convertibility. However, the reality is that the Peoples Bank of China (PBoC) still sets the daily fixing and the movement in the CNY will still largely depend on where this fixing is set.
Ultimately a move towards a more market based currency will need to allow the market to determine the level and movements in USD/CNY. This may still be a long way off. In the meantime it seems unlikely that the authorities will intervene as aggressively to weaken the CNY as they have done in recent weeks, with a breach of USD/CNY 6.15 likely prove short lived.
China’s still healthy external position and likely resumption of capital inflows will mean that appreciation pressure on the CNY will return and a move back to around 6.00 by end 2014 remains on the cards.