I’m going to talk about things in this post in relation to the earlier headline here. It’s storytelling time and might as well since we have to wait on the ECB and major US data later today anyway.
To give a bit of context, what the Chinese central bank is requesting is rather unorthodox and it isn’t something that you can really do with a pure free-floating currency. You can’t just call up banks and tell them not to square their dollar positions until later, just so to prevent further pressure on the domestic currency during the interim. But it is what it is and speaking from experience, things like this don’t tend to come up very often unless officials are getting desperate.
I had the fortune of going through this situation once during my time on the trading floor and I guess you could say this only would happen to countries where the FX market is not exactly internationalised fully and/or representative of a free-floating currency. I can’t be too specific due to certain reasons, which I do not want to get into trouble for.
Back in 2016, Trump surprised the world by winning the US presidential elections. If you recall, that was followed by a strong wave of dollar-buying and in particular, emerging market currencies were hurt the most.
The FX market where I was involved in trades somewhat similar to the yuan, that it had both an onshore and offshore market. The latter being non-deliverable forwards (NDFs), which are quite common for emerging market currencies (mainly used for hedging purposes) I would say. Typically, when the onshore market closes, the offshore market would then provide an indicative pricing of where the currency should be trading or at least give a rough estimate.
In this instance, when I stepped into the office in the early morning, the NDFs were trading more than 13% higher (weaker local currency) than what the onshore market closed the day before. It was quite unprecedented and it would mark a fresh new figure and all-time low in the local currency if the onshore market were to open thereabouts.
So, cue the panic. We had to check with other banks to try and get a sense of where they are also seeing price in the market and if we are really going to start quoting rates at that level.
But right about 30 mins before the market open, came a call from the central bank. The direction was that they needed more time to sort this out and think about ways to try and maintain order, whatever that may be in their books.
So, for the first few hours of what should be a normal trading day, we as a bank were not allowed to provide any quotes to other banks and to clients for the onshore market. In other words, there was no price for the local currency whatsoever during that time. Yes, the currency basically had no existence.
There were a lot of politics involved as to why we had to listen to the central bank and not act responsibly, but I’m not going to go into that and I can imagine it is a similar case for China at the moment as well. The central bank made sure we did stick to the script by sending agents to each bank by the way.
This continued until right after midday and eventually, we were able to quote our clients again. At what rate you might ask? The same exact rate that the onshore market closed the day before. And moving forward, each day we will have just gotten one fixed rate from the central bank for the onshore market and that would be it for the whole day. In other words, it is an artificial exchange rate.
We would use that rate to square our positions as the central bank introduced other means to alleviate pressure on the local currency. The first was to invalidate the offshore market. That meant officially stating that all hedging activities must be done in the onshore market and that NDFs were no longer recognised. That helped shut the door on a number of foreign investments.
And then, they introduced a ruling whereby any incoming funds in foreign currencies had to be converted immediately to the local currency at 75% notional amount. I had clients lose millions because of this as they had forward contracts which were supposed to do these conversions at a later date but they have to be utilised immediately as and when the funds came in. Swap points on long-term FX contracts can be a real bitch, unfortunately. And their appeals to the central bank were all brushed aside, pfft.
Anyway, the situation was basically this. We had a fixed rate, which was determined by the central bank, to square our dollar positions each day and that was the cost price for the day essentially. It was a make-the-rules-up-as-you-go kind of situation and we were in no place to question that.
We all knew that the exchange rate observed was basically the artificial rate when in truth, the local currency should’ve traded much, much lower. For a FX market this small, I reckon the central bank could still get away with something like this – although it did crop some warnings by the IMF.
And until today, the local currency hasn’t really recovered from that situation even if some of the measures undertaken at the time have already been rolled back in recent years. The damage has already been done and all thanks to a central bank that was desperate and struggled to manage its FX reserves over the years.
With China, the backdrop sounds similar but their predicament is slightly different. For one, Beijing has plenty of FX reserves at their disposal. Secondly, while they still have certain controls over the exchange rate, it is more open for international trade.
But when local officials start to resort to the same kind of tactics that are “off the books”, you know that we are reaching a point of desperation that is not typically seen in free markets.