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Yuan decision just part of the reform process

By Andrew Colquhoun (China Daily) Updated: 2015-08-25 10:45

Rate change will help meet the IMF's criteria for including currency in the SDR basket

The depreciation of the Chinese yuan by around 3 percent against the United States dollar has underscored the pressure on the country's economy. It has also highlighted the commitment by authorities to market-oriented reform.

Fitch Ratings Inc, a globally-recognized statistical rating organization, sees the reform process as crucial to tackling unresolved structural weaknesses. Allowing markets a freer role at this stage will entail risks. But the authorities' calculations seem to be that the risks of doing nothing are far greater.

The People's Bank of China, or the central bank, moved its daily yuan reference rate against the dollar down for two consecutive days earlier this month. The 1.9 percent move on Aug 11 marked the largest one-day devaluation since 1993. The cumulative depreciation was more than 2.8 percent.

The yuan-dollar exchange rate is controlled, with daily moves limited to within 2 percent of a central fixing rate set by the PBOC. The central bank has presented the move as technical and operational in nature, highlighting that the market rate had deviated consistently from the central fix for several months. The PBOC argued that the move would help push it closer to the market equilibrium.

The change will help meet the IMF's criteria for including the Chinese currency in the basket making up the Special Drawing Rights, which includes the dollar, the euro, the yen and the pound. A decision is expected from the IMF's executive board in October or November this year.

But it is difficult to separate the depreciation entirely from weak economic data released last month, particularly exports and fixed-asset investment, and from broader concerns about growth.

It may be possible for the PBOC to describe the development as technical, while the direction of movement of the currency highlights wider pressures on the economy.

So far, the depreciation is limited compared with other large emerging markets. The currencies of Brazil and Russia have depreciated by 35 and 45 percent respectively against the dollar during the past year.

It should also be seen in the context of the appreciation of China's nominal effective exchange rate, which has increased by 3.6 percent annually. By comparison, South Korea's rate appreciated by 2.1 percent, while Japan's depreciated by 1.1 percent during the same period.

As such the depreciation seems modest and broadly consistent with the unchanged monetary policy stance announced by the PBOC in its report on Aug 7.

Changes in the method for setting the exchange rate are in line with other steps to liberalize key areas of the country's capital markets. Recently, this has also included the move to allow banks to issue large-denomination certificates of deposits at unregulated rates since June.

The evidence suggests the authorities have accepted in practice the decision to allow the movement of large sums of capital. But allowing market forces a greater role could create higher volatility and uncertainty.

By keeping the nominal exchange rate more stable until Aug 11, the authorities had to allow foreign-exchange reserves to absorb the pressure that had emerged on external accounts.

China's foreign reserves have fallen from an all-time high of $3.99 trillion at end of June last year to $3.65 trillion as of the end of last month. The decline is not yet a negative factor from an external liquidity standpoint as the reserve stockpile is clearly immense.

Yet it has added to the challenge of managing macroeconomic policy by destroying liquidity in the domestic financial system and blunting the broader easing of monetary policy that began in earnest last November.

The authorities' interventionist response to the bursting of a bubble in equities last month showed that there are still limits to allowing market forces more scope. Allowing more market-fueled volatility may seem counter-intuitive while the Chinese economy struggles to overcome the structural weaknesses that have built up during the investment-heavy growth period.

This includes the likelihood of widespread debt problems in the corporate and local-government sectors. But market forces are likely to be an essential part of the solution to these problems - by helping allocate resources more efficiently.

A more substantial devaluation of the yuan, if it emerges against Fitch's expectation, would add to the economic challenges facing the Asia-Pacific region. It could potentially broaden the impact for those economies that are more exposed to Chinese consumption, including major commodity exporters such as Australia and Indonesia.

The author is Fitch's analyst and the senior director of Fitch's sovereign rating team.

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