China has done it again: without warning Beijing moved the goalposts and changed the rules of its currency fixing mechanism... again. 

As reported first thing this morning, China announced it would introduce a new "counter-cyclical factor" to reduce exchange-rate volatility while undermining efforts to increase the role of market forces. In some ways this announcement was not unexpected: recall that after a period of eerie stability, on Thursday the Yuan surged shortly after China's downgrade by Moody's, which prompted speculation that the central bank was directly manipulating the currency as the PBOC’s daily fixings had "materially diverged" from the prescribed formula, resulting in a gap between the reference rate and currency’s spot value.

Roughly at the same time as a similar move was taking place on Friday, Bloomberg first reported and China later confirmed that policy makers would add a “counter-cyclical factor” to the yuan’s daily fixing, a move which "would give authorities more control over the fixing and restrain the influence of market pricing." Subsequent detailed revealed that authorities would change the daily $/CNY fixing mechanism, so that the change of the fixing from the previous day’s close would also take into account a “counter-cyclical adjustment factor” (how this is determined is not specified though), in addition to the USD’s movement against a basket of currencies.

While the practical consequence was a surge in both the onshore and offshore Yuan to three month highs, traders and commentators were left confused by this latest intervention by Beijing into what has become China's fulcrum security.

“The counter-cyclical adjustment factor sounds like an increased role for the fixing to be nudged away from where markets would set it,” Sean Callow of Westpac Banking Corp told Bloomberg. “The authorities’ actions give the impression that they are more worried about yuan stability than declared in their public statements.”

So what is it?

First, some background.

China's original CNY fixing mechanism introduced in August 2015, at the same time as the country's devaluation, was cast as a function of 3 elements: i) the previous day’s close; ii) overnight movement of the USD against a basket of currencies; and iii) also what is called “market supply-demand conditions” (the last factor was also vague and not well-defined). As documented at the time, and as Goldman reminds us, a series of weak CNY fixings in late 2015 and early 2016 (apparently attributed to unfavorable “market supply-demand conditions”) prompted intense market worries, which in turn led the PBOC to subsequently set the fixings stronger. The PBOC also adjusted the fixing mechanism in May 2016, removing the “market supply-demand conditions” element as a factor determining the fixing (but saying this factor affects intraday CNY move).

While the post-May 2016 fixing mechanism somewhat improved transparency, it also made the CNY more rigidly linked to the basket of currencies. And, as Goldman observed earlier, "for such a sizable economy as China, a pegged (soft or hard) exchange rate is arguably not the most suitable long-term arrangement, as the external stability benefits may be outweighed by the associated cost of limits to the central bank’s autonomy over monetary policy, especially if the capital account is to be eventually opened up (per what the “impossible trinity” thesis suggests, an economy cannot have a pegged exchange rate, autonomous monetary policy and an open capital account at the same time).

Fast forward to the present, when over the last couple of weeks Yuan traders had observed that CNY fixings had deviated quite notably from the past pattern on the strong side vs. the basket, and model-implied "fair value", as shown in the chart below.

To be sure, this did not necessarily mean the authorities have been trying to stabilize/strengthen the CNY. As Goldman explains, the Chinese central bank had been allowing larger CNY flexibility on the weak side vs. the fixing during intraday sessions (possibly reflecting reduced FX market operations by the authorities). The intra-day moves have had the effect of offsetting the stronger fixings, thus on a net basis CNY has in fact not been significantly out-performing, given the backdrop of a progressively weaker USD.

As first noted here on Wednesday evening when we showed the spike in the Yuan to 2 month highs, during intraday sessions on Thursday and Friday the CNY notably strengthened vs the USD. It was also possible that these might be temporary moves driven by the authorities’ response to the Moody’s sovereign downgrade on Wednesday and to the news about the CNY fixing mechanism change today. As Bloomberg added, while the yuan has fluctuated in a narrow band around 6.9 per dollar for most of this year, the currency strengthened over the past two days amid suspected government intervention. The yuan gained 0.1 percent to 6.8622 per dollar as of 5:57 p.m. local time Friday, heading for the biggest two-day advance since late March.

Today, it was finally unveiled that the sharp moves in the Yuan were in preparation for today's announcement of a new CNY fixing mechanism. Under the new reference rate formula unveiled by the PBOC, institutions that provide quotes for the fixing will now add an intangible counter-cyclical factor to their existing models, which take into account the previous day’s official closing price at 4:30 p.m. local time and changes in baskets of currencies. Banks are currently tweaking and testing their models and will start providing quotes using the new system soon, Bloomberg reported.

In an amusing aside, one which may have been taken straight from the worry-list of the Korean central bank, Bloomberg added that "China’s foreign-exchange market can be driven by irrational expectations, resulting in "unreal" supply and demand that increases the risk of overshooting, according to an official statement on Chinamoney.com, which is run by China Foreign Exchange Trade System. The counter-cyclical factor may ease "herd actions" and help guide investors to pay more attention to economic fundamentals, according to the statement."

In any case, explaining the recent sharp moves, on Friday CFETS said that the recent observed changes in CNY fixings have already reflected the new fixing mechanism, and said that more changes in the fixing and intraday trading patterns are possible in the days ahead.

According to Goldman, in the near term, the authorities might continue to keep CNY relatively strong (as they did in the last two days) to mitigate potential market worries that the mechanism change could be a precursor to the late 2015/early 2016 experience of discretionary currency weakening.

Which of course does not preclude the new regime from becoming the precursor to another deleveraging. Bloomberg points out that for China’s government, the existing market-based fixing system’s downside is that it makes the exchange rate more difficult to control. The yuan’s 6.5 percent slide in 2016 created a vicious circle of capital outflows and bets on further currency weakness, prompting officials to burn through more than $300 billion of foreign-exchange reserves and introduce tighter capital controls. As such, the new fixing formula may be "a cheaper way to stabilize the yuan. Officials have already used the reference rate to guide the currency higher in recent weeks, setting the fixing at levels that were consistently stronger than analysts predicted" and certainly in the hours after the Moody's downgrade when the above mentioned "herd action" may have prompted another sharp selloff absent central bank intervention in the other direction.

“The PBOC has been fixing with a major dose of discretion,” said Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong. “We can consider this ‘counter-cyclical adjustment factor’ as using that discretion.”

And while in the short run the PBOC might continue to lean toward a stronger CNY to pre-empt market uncertainty about the fixing mechanism change, "the longer-run implication for the CNY regime is still unclear at this point", according to Goldman's MK Tang.

Whether the change implies a shift toward or away from a more market-oriented CNY regime would depend much on how the authorities set the adjustment factor in practice. For instance, if over time the authorities are tolerant of more intraday CNY volatility, and the adjustment factor is set only to lean against the wind of large market swings, then the new mechanism could pave the way for the CNY to become less linked to the basket and more flexibly traded. In contrast, if the adjustment factor is set to actively reflect the policymakers’ cyclical macro objectives, then the transparency and market-orientation of the CNY regime could suffer.

It is the latter that is of greater concern to the market. According to ING's Tim Condon, "by taking steps to scale back the market’s role in the fixing formula, authorities may undermine efforts to make the currency more freely traded", which at least on paper, has been the government's intention for years, and is why the IMF recently added the Yuan to its SDR basket.

“If the yuan endgame is a free float like the other major currencies, refining the PBOC fixing mechanism is a retrograde step,” Condon said.

For a nation that seeks to micromanage every aspect of its economy, it is far likelier that the correct explanation is that China is seeking to further limit volatility, and thus market forces, at a time when even the rating agencies admit China has a "debt problem." It will however make it even easier for China to punish speculators, i.e., those who short the currency (before such time as Beijing admits another devaluation is necessary). As Citi's Siddharth Mathur comments, "while this change may not soothe investor concerns about the renminbi's outlook over the medium term, it provides authorities another mechanism with which to check the pace of deterioration in sentiment in the short run. It thus makes it harder still for market participants to profitably 'speculate' on renminbi depreciation."

So what are the preliminary conclusions from China's unexpected revision of its currency fix?

First, here is Goldman's take:

...in the short run the authorities might continue to lean toward a stronger CNY to pre-empt market uncertainty about the fixing mechanism change. But it is still too early to judge the implication for the CNY regime in the longer run, as it depends much on how the authorities set the adjustment factor in practice.

And here is Citi:

In summary, we see today's reports of a change in the formula used to determine the fixing of the daily USDCNY midpoint as helping to contain the pace of deterioration in market sentiment towards the renminbi. We do not view this shift as a regime change, and we anticipate that for the most part the USDCNY fixings will remain consistent with established pattern.

Last but not least, a question numerous trading desks have raised: why after one year without any changes to the Yuan fixing mechanism, did the PBOC change it now... and is something significant about to be revealed, "something" which would result in a dramatic shift in market sentiment prompting the PBOC to take preemptive steps to address it in advance?