China needs more transparency now

On August 11, the Chinese yuan fell 1.8 per cent against the US dollar, the sharpest daily decline since the currency was de-pegged from the greenback in 2005. So far, the yuan - also known as the renminbi - has depreciated around three per cent to its lowest value against the dollar in over four years. The move comes as a result of a change in the system to determine the exchange rate.
Before August 11, the exchange rate was determined daily by the People's Bank of China, or PBOC, after considering quotes for the dollar-yuan from selected large banks, called "market makers". Neither the quotes submitted by the banks, nor the system used to determine the daily reference rate were made public. Once determined, the yuan was only allowed to move a maximum of two per cent each day. The following day, the process would be repeated. In practical terms, the rate was determined by the central bank.
Following the August 11 devaluation, the PBOC announced that the system to determine the daily rate had been changed. The new mechanism is similar, but the banks are asked to take into consideration three factors when submitting quotes: the previous day's closing rate, supply and demand factors and other major currency movements. The rest of the process remains unchanged: the central bank complies these quotes - which are not published - and determines the daily rate with a method that is not revealed. The key change here lies in the fact that, by asking market makers to take into account market factors, the exchange rate system is considered to be closer to liberalisation.
Why is that important? Because China will soon need external funding, and to do so it will have to open its capital account and convince international investors to use renminbis to store part of their reserves. The country has already been working on it: China already set up offshore yuan-trading hubs, launched the Shanghai-Hong Kong stock connect, established free-trade zones and widened the yuan trading band. If the PBOC's claims are real and the yuan's fluctuations are accurately based on market dynamics, this move would be a serious sign of intent that China is opening up its economy to foreign capital. Furthermore, the latest move would improve the yuan's chances to be included in the IMF's Special Drawing Rights basket next year, facilitating its internationalisation.
A second factor explaining this change is economic momentum. Many think that the move was intended exclusively to boost the economy's manufacturing and export sectors. Growth of gross domestic product has stabilised at seven per cent year-on-year as of late, but this year's large export contraction, the 18-month long property market slump and the recent stock market correction could trigger a rapid deceleration which the authorities are trying to avoid.
In reality, the devaluation seeks to achieve both goals. The Chinese economy has been on a slowdown specifically because it is undergoing a change in economic model. In the past, the yuan was criticised for being undervalued. But between mid-2010 and the start of 2014, China appreciated its currency by more than 10 per cent against the US dollar. Since then, the nominal effective exchange rate - a trade-weighted exchange rate measure - showed that the currency strengthened by an additional 12.8 per cent against its main trade partners in the last 12 months as of June. In fact, the IMF declared in May that the yuan was not undervalued anymore. So the recent devaluation could be considered a realignment with fundamentals after a rapid appreciation. The development is welcome, but a word of caution is needed. If the exchange rate was to be truly market determined, it would probably contribute to long-term growth, but it also means the yuan would experience swings, which may destabilise the economy. A second factor to be considered: if the PBOC is not sincere in its intention of allowing market forces a greater role, investors will punish the economy by pulling investments out.
The writer is an economist at Asiya Investments Company. Views expressed are his own and do not reflect the newspaper's policy.