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How FX Reserve Requirements Can Influence Yuan Appreciation

Article Quant Q&A · Author: Student
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Summary

This explanation describes how foreign-exchange reserve requirements can affect the onshore yuan market when capital movement is restricted and onshore and offshore rates differ. A central bank seeking yuan appreciation can sell foreign-currency reserves to buy yuan, increasing demand for the domestic currency. To resist appreciation, it can instead expand domestic money and purchase foreign currency, though this may add liquidity and inflation pressure; issuing local-currency bonds can sterilize that liquidity, with potential carrying costs.

Raising reserve requirements on foreign-currency holdings can lock up part of capital inflows and make foreign-exchange funding more expensive. The answer says institutions may respond by increasing positions that buy dollars with yuan, while signaling that further yuan appreciation is unwanted may also affect market expectations. The direct effectiveness is described as uncertain. This is a qualitative policy explanation rather than a quantified analysis of the cited episode or a detailed treatment of the policy mechanism.

Key ideas

  • Selling foreign reserves to buy yuan can raise demand for yuan and support appreciation.
  • Buying foreign currency with newly created domestic money can counter appreciation but may add inflationary liquidity.
  • Sterilization through domestic bonds can absorb excess liquidity and may impose costs when domestic rates are higher.
  • Higher FX reserve requirements can increase funding costs and encourage dollar buying with yuan.
  • Policy signals may influence expectations beyond the direct market effect, whose size is uncertain.

Tags

ForexChina marketsRisk management
Full text
# Central bank of china foreign currency reserves


# Central bank of china foreign currency reserves












https://www.bloomberg.com/news/articles/2021-05-31/china-moves-to-cool-yuan-rally-by-raising-fx-reserve-requirement?cmpid=BBD053121_NEF&utm_medium=email&utm_source=newsletter&utm_term=210531&utm_campaign=nef

The Central bank of china has just increased the reserve ratio for foreign exchange holdings, to rein in the CNY appreciation. This reduces the supply of dollars and other currencies onshore according to the article. My interpretation is that it should reduce demand of yuan in exchange for foreign currency, why is this?

## Answer by AKdemy (score 1)

https://quant.stackexchange.com/a/64364

China, unlike some other countries does not allow free movement of capital (FX). Hence you have an onshore and offshore market and the FX rate is not allowed to move freely.

Think of it the other way around first (which I believe is easier to grasp). If China wanted the Yuan to appreciate, it could sell its dollar reserves (the actual composition of reserves is not official but I think it is safe to assume it will be predominantly USD assets) to buy Yuan on the foreign exchange markets. The Yuan would appreciate because it increases the demand for Yuan (and increases supply of USD).

On the other hand, if the FX rate is assumed to be too high, the central bank could simply increase money supply (essentially print money) and buy foreign currency. Generally this may seem to be a small problem for domestic money supply as this money is used to buy foreign assets. However, usually it finds its way back via increased exports. That causes a problem (inflationary pressure). To offset this, a central bank can sterilize this intervention, which is usually done by issuing bonds in domestic currency which sucks out the excess liquidity. One problem with this approach is that interest rates are typically higher domestically, meaning the central bank tends to lose money doing this.

Reserve requirements (not necessarily foreign) are an alternative. In order to being able to meet the increased RR, parts of capital inflows will be locked in and it makes foreign exchange funding costs higher. It will also require existing positions to be increased. This means buying USD with Yuan. How effective this really is my be disputable. However, central banks also frequently engage in changing expectations and if the signal is that further appreciation is not wanted, market players will be unlikely to "bet" on this. So a potentially small direct market impact, may have a sizeable indirect impact via expectations.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.