Beijing's tolerance for the yuan's massive rally against the dollar over the last six weeks has mystified many market observers, but some traders in the domestic forex market believe the anomaly is a harbinger of a new wave of currency reforms. In a global environment characterised by rampant money printing by major developed economies, China has nevertheless allowed its currency to appreciate in inflation-adjusted trade-weighted terms for seven months to April, making its exports less competitive.
---- Yuan not in one-way rise, moves to more flexible regime
---- Reforms needed as China economy enters crucial time
The appreciation has also attracted inflows of speculative capital that are distorting China's trade. Since the People's Bank of China (PBOC) has the ability to stifle the rally at will, either by massively intervening by buying up dollars or by using the official guidance rate to strangle market exuberance, its passivity has mystified traders.
The PBOC has given no public explanation, apart from repeating assertions that the currency has reached a rough equilibrium value. Bemused market observers alternately attributed the change to diplomatic posturing, to an attempt to encourage foreign companies to settle trade in yuan, or to set the stage for reforms to the currency regime itself. Traders who spoke to Reuters are increasingly coming around to the latter view. "The yuan's appreciation is different this time around," said a dealer at a major Chinese commercial bank in Shanghai. "I would not call it a new round of appreciation but rather see it as setting the stage for a more flexible exchange rate regime."
Market players are already speculating that the upcoming plenary session of the ruling Chinese Communist Party in October will be used as a platform to announce a slew of reforms to the Chinese economy, and to the currency market in particular. Traders are expecting announcements regarding widening the trading band, which currently keeps the exchange rate within 1 percent of the daily official midpoint rate, complemented by steps to make the midpoint more responsive to supply and demand. They also expect more rules easing the movement of the currency in and out of the country.
As evidence, traders point to the fact that the Ministry of Commerce, which ordinarily can be counted on to make public statements endorsing yuan "stability" - which traders read as code for maintaining restrictions - has been silent on the issue since March.
"Only true leadership consensus could prevent powerful interest groups representing Chinese exporters, such as the Commerce Ministry, from harping on the necessity of a stable yuan," said a senior trader at a state-owned bank in Beijing.
Zhang Zhiwei, chief China economist at Nomura in Hong Kong, agreed that the political barriers to liberalisation have diminished. "There's not really that much resistance," he said. "There aren't many interest groups opposing currency reform. It's just a question of finding the right timing."
By keeping the exchange rate low and tightly restricting the capital account, Beijing was able to maintain an impressive economic growth rate for decades. But it was not without costs. The global financial crisis made it clear that China cannot remain dependent on overseas demand indefinitely, and the stimulus response that insulated China from the worst effects of the global downturn has produced a massive overhang of bad debt. "For a long time, the inflexible exchange rate has hijacked China's monetary policy," said a dealer at an Asian bank.
To keep a lid on the yuan, the central bank has been compelled to buy up foreign exchange entering the economy and trade it in for yuan. The large amounts of yuan have entered the domestic money supply, aggravating inflation and facilitating other distortions, including industrial overcapacity. At the same time the policy left China with the world's largest pool of foreign exchange reserves, which have been steadily depreciating in value as the dollar has lost ground against the yuan.
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