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The Chinese government needs to increase the value of the yuan to properly deal with its dramatic rise in FX reserves, according to Societe Generale's Glenn Maguire and Wei Yao.

Up until now, the People's Bank of China has been exclusively using monetary policy like interest rate hikes and increases in the required reserve ratio to tame liquidity. It has failed, however, and if it was to continue down this course, it could cause a liquidity crisis.

From Maguire and Yao:

China’s quantitative approach to monetary tightening has almost certainly reached its limit. Between 2004 and now, the share of FX reserves sterilised by required reserves and open market operations declined from nearly 100% to around 80%. Meanwhile, the required reserve ratio was raised from 7% to an unprecedented 20.5%. Yet, China’s economic circumstance demands even more!

In Q1, liquidity added via FX reserves accounted for 40% of new broad money supply. If China were to sterilize even 80% of that, then the RRR would need to be set at 32%. Such a level would cripple the fluidity of the banking system.

Left with little choice, China will now engage in a one off revaluation, according to Maguire and Yao. But the PBoC's main goal in policy thereafter will be to tame speculation, and dismiss the assumption that this will happen again.

From Maguire and Yao:

We believe that reform will centre on a new exchange rate mechanism that aims to allow currency appreciation whilst deterring damaging and, now, unmanageable speculative inflows. We believe in the first instance this will take the form of a further one-off revaluation of the currency, immediately followed by a period of depreciation (similar to the famous BoJ bear traps). A widening of the fluctuation band will then allow the RMB to move more significantly on an intra-day and intra-week basis to introduce more volatility. SAFE and the PBOC will therefore have the ability to punish speculators and ultimately dissuade speculative inflows. Indeed, sporadic large adjustments in the fixing (either way) could be employed as a further tool against speculation.

So while we can expect one dramatic revaluation, expect a more cautious approach aimed at taming speculators thereafter.

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Note step 1, the revaluation, with a bounce back thereafter, and then a gradual movement toward more appreciation.