Why making it easier to short a currency can weaken it
In an effort to slow the RMB's appreciation against the dollar, the People's Bank of China (PBoC) eliminated a 20 percent reserve requirement on forward contracts that sold RMB, making the RMB easier to short. But how can simply making it easier to short a currency actually cause it to depreciate?
Selling a forward contract for RMB is a bet that the currency will weaken by the time payment is due. Somebody must be on the other side of this trade. We often imagine this as a company hedging a future payment by locking in a rate today. For example, imagine a company that earns USD but has a Chinese distributor they need to pay in 30 days. The company may prefer locking in a USD/RMB forward rate rather than facing whatever it is in 30 days. If the market actually worked this way, making it easier for people to sell forward contracts shouldn't impact the RMB.
However, things change with a dealer in the middle. Rather than connecting buyers and sellers, like a broker, a dealer buys and then resells products. As Perry Mehrling points out, dealers often buy when there is excess selling pressure and sell when there is excess buying pressure, which can lead to inventory risk.
Suppose a dealer buys a forward RMB but cannot find a buyer. The dealer is long RMB because if the RMB appreciates they can buy at the forward contract's rate and then sell at the market rate, profiting from the difference. But because dealers' profits come from bid-ask spreads rather than speculation, they are likely to hedge this long position by going short RMB. This would likely involve selling RMB and buying USD in the spot market. If the RMB depreciates relative to USD the dealer benefits from this short position, but if the RMB appreciates they benefit from the long position.
The PBoC seems to be targeting the dealer's short position, which they take on as a hedge, because more people selling RMB and buying USD pressures the RMB to depreciate. If we didn't have a dealer in the middle hedging inventory risk, simply making it easier for speculators to short RMB would have a weaker impact on the exchange rate.