Widen the trading band of the yuan

From: China Daily Updated: 2014-03-18 09:46
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On Saturday the People's Bank of China (PBoC) announced that, as of March 17, it would widen the trading band for the yuan from +/- 1 percent to +/- 2 percent. The widening was widely anticipated, although its timing was earlier than most people expected.

Following the recent depreciation, the band widening is a strong signal that policymakers are moving towards more exchange rate flexibility over time. More flexibility is crucial for the overall process of monetary and exchange rate reform-China needs greater exchange rate flexibility before further opening up its capital account to financial flows. It also helps breaking the perception of a one-way bet on the yuan. This has recently led to sizeable financial inflows that were complicating monetary and exchange rate policy and therefore frowned upon by financial policymakers.

However, we do not think much will change at the day to day level on China's foreign reserve market in the short term. The People's Bank of China will continue to set the fix-the center of the now enlarged band-at the beginning of every business day. Moreover, it will continue to heavily manage the spot rate. China has a structural surplus on the foreign reserve market of US dollar 300-400 billion per year-from the current account surplus and net FDI-which, at least in our forecast, will not easily go away in the coming years on current trends.

With a large structural surplus on the foreign reserve market, the yuan remains in the hands of policymakers. Net financial flows can at times be large enough to create temporary depreciation pressures, and the PBoC will be happy to let them exert temporary depreciation pressure. But, looking at the stock and composition of foreign assets and liabilities, the size of such net financial flows is simply not going to be large enough, compared with other balance of payment components, to drive the foreign reserve market.

That means that underlying pressures will in the coming one to two years remain toward appreciation, leaving the yuan in the hands of policymakers.

Thus, while we expect more volatility in the yuan/US dollar rate, initially, this will in large part have to be policy induced. Eventually, following further appreciation of the yuan and/or more capital outflows, volatility can become more truly market-driven.

What will happen in the coming days? Thinking about the PBoC's considerations, the recent depreciation has been fairly successful in making a point about two-way risk, and the band widening will further help making that point. Also, the PBoC may want to show to broader policymaking circles and domestic economic players that the yuan is still solid. And the recent depreciation involved a lot of intervention on the foreign reserve market, which further increased the PBoC's foreign reserve reserves. Therefore, we would not be surprised to see some strengthening of the yuan vs the US dollar this week, although it is hard to be sure.

What about the trend?. As China's productivity catch-up is clearly not completed, the CPI-based real effective exchange rate will have to continue appreciating, trend-wise. In our analysis, recent developments show that, overall, China's manufacturing sector is handling the trend of real effective exchange rate appreciation well. It is still gaining global market share. And it is strengthening its competitiveness by moving up the value chain. Therefore, we expect the trend towards a stronger yuan to last for quite some time.

The author is chief China economist with The Royal Bank of Scotland.

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