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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?

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    $\begingroup$ Are you asking why are they trying to curb yuan down or why is the move curbing the yuan down ? $\endgroup$
    – Mayeul sgc
    Commented Jun 1, 2021 at 2:06
  • $\begingroup$ why the move should curb the yuan down $\endgroup$
    – Student
    Commented Jun 1, 2021 at 8:26
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    $\begingroup$ Think of it like raising margin requirements - you're reducing the potential return which should reduce demand. $\endgroup$
    – user42108
    Commented Jun 1, 2021 at 13:37

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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.

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