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Editorial: It’s the Right Time for Further Tweaks to the Yuan Fix

By Hu Shuli

In the two years since Chinese authorities made a major change in how the reference rate of the yuan is calculated against the U.S. dollar, the currency has gone through some bumpy times. But the yuan’s exchange rate has been stabilizing, and discussion about further changes has resurfaced.

The range of the yuan’s daily fluctuation against the U.S. dollar is no longer the key point. How to set the midpoint rate, around which the yuan is allowed to trade, is the difficult part. The flexibility of the yuan’s exchange rate depends on the progress of supportive reforms.

In its recent annual report on China’s economy, the International Monetary Fund said the renminbi “remains broadly in line with fundamentals” but also called for more efforts for greater exchange-rate flexibility. The Chinese government’s financial work meeting in July, which takes place every five years, also reiterated its goal to deepen the yuan’s exchange-rate reform.

The goal of renminbi reform is clear. But the process is not smooth. Authorities vowed to build a managed floating exchange system based on market forces as early as 24 years ago. In 2005, the yuan’s rate was no longer pegged to the U.S. dollar, but started to be based on a basket of foreign currencies. In July 2008, when the global financial crisis hit, the yuan was virtually pegged to the dollar again until resuming the previous system in June 2010.

Starting in August 2015, the yuan’s guidance rate also took into account the closing price of the previous day. It was aimed at adjusting the yuan’s overvalued rate against the dollar at a time when China’s stock markets experienced a crash and the economy faced downward pressure. However, the move opened a Pandora’s box in the yuan’s depreciation.

As the expectations of further depreciation spread and the foreign-exchange reserve shrank, the central bank adjusted the calculation method of the yuan’s daily fixing several more times. In January 2016, the basket of currencies started to weigh more on the yuan’s rate fixing. In May of this year, the central bank added the “countercyclical factor” to the fixing in order to offset the “herd effect” among investors that authorities believe often amplifies market volatility. As a result, the influence of the closing price on the yuan’s rate has been diminished, and the dollar index’s role strengthened. The market has been struggling to speculate what kind of countercyclical factor is being considered in the central bank’s changes of daily fixing.

It may be too early to conclude that the inclusion of a countercyclical factor is a step backward. The central bank has made it clear that the new factor will be used to avoid “irrational” moves while respecting the market.

However, the IMF said the countercyclical factor may reduce the role of market forces in favor of more administrative control.

An ideal exchange rate decided by the market needs three elements: the market decides the midpoint rate; no fluctuation range or the ranges should be much larger than the current limit of 2%; and the central bank does not make regular interventions unless the exchange-rate fluctuation has reached a point that it is likely to affect market stability or bring systemic risk.

The difficult part of exchange-rate reform lies in the calculation of the midpoint rate. Many people call for the expansion or termination of the daily fluctuation range against the dollar. But the real daily fluctuations rarely reach the existing range of 2%.

CIB Research, a research institute associated with Industrial Bank Co. Ltd., found that after the countercyclical factor was included, the annualized fluctuation of the midpoint rate, which is used to measure exchange rate flexibility, falls back. It indicated that expanding the fluctuation range does not necessarily increase exchange rate flexibility. The next change needs to add more flexibility to fixing the midpoint rate in both directions.

There are few cases in which one can take a straight path to reach a target. Sometimes people need to take a roundabout way or even one step back in order to move further ahead. But the ultimate goal is still to reach the target.

It is important for the government to manage expectations of the exchange rate that often affect the yuan’s fluctuations. But the impact of expectations should not be exaggerated. The exchange rate reforms since 2005 have focused on preventing market expectations from moving in just one direction. Before 2014, the expectations were mainly that the yuan would strengthen. After that, most analysts expected that the yuan would weaken.

In essence, the exchange rate is determined by the basic economic factors between different countries, including economic growth and their ability to attract foreign investment. The deciding factors are not the exchange-rate policies, but the fiscal power; transparent and independent currency policies; and the capability of keeping low inflation and a stable financial system, as well as a fair and just social environment. To improve China’s economic basics, a number of supportive reforms are needed to improve sustainable growth, including reforms in state-owned enterprises, market access, the financial system and social security.

These are already on the agenda of China’s economic reform and development. Action is the key.

There are also things the authorities can do on the exchange-rate market, such as increasing the number of institutions that can participate in transactions, expanding the trade of renminbi-denominated derivative products, improving infrastructure of transactions, and creating a more-transparent market environment. With these improvements, authorities will find it easier not to panic, and investors can get used to a more-flexible exchange rate, and more offshore investors may be attracted.

It is not easy to find the right time to make further exchange rate reforms. But the opportunity also goes by quickly. The time window for reform has been opened, now that the downward pressure on Chinese economy has been easing, the risks of financial markets have been receding, and the bullish performance of the U.S. dollar in the past two years may come to an end. At least the timing is much better than it was in August 2015.

Hu Shuli is the editor-in-chief of Caixin Media.

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