China's New Yuan Index: Here's What the Market Needs to Know

China Intends to Loosen Yuan's Peg to Dollar: WSJ
  • The what, why and how of the PBOC's latest currency move
  • Central bank seen setting the stage for further depreciation

A new currency index in China is causing a stir as policy makers seek to refocus the market’s attention away from the yuan’s moves versus the dollar and instead compare performance against a wider selection of peers.

The CFETS RMB Index was unveiled late on Friday and the People’s Bank of China said yuan fluctuations mustn’t be measured in terms of the greenback alone, adding that exchange rates are a reflection of trade and investment with multiple countries. The new measure monitors moves against a basket of trading partners’ currencies and was introduced by China Foreign Exchange Trade System, an arm of the PBOC that facilitates interbank trading.

Here’s what the market needs to know about the new gauge and what it means for the exchange rate, which is poised for its lowest close in four years:

What is it?

The CFETS RMB Index will measure the yuan’s performance against a basket of 13 currencies, with weightings based mainly on international trade, according to the PBOC. The measure has an end-2014 level of 100 as its base level and will be published regularly, it said, without providing details of frequency.

The dollar has the largest weighting with 26.4 percent, followed by the euro and the yen with 21.4 percent and 14.7 percent, respectively. The measure also includes the currencies of Hong Kong, the U.K., Australia, New Zealand, Singapore, Switzerland, Canada, Malaysia, Russia and Thailand. The U.S. accounted for 14.2 percent of China’s trade this year through November, while the European Union had a 14.3 percent share. About 95 percent of the yuan’s onshore spot transactions were against the dollar in 2014, according to a China International Capital Corp report.

CFETS will publish two other trade-weighted yuan indexes that reference performance against the IMF’s Special Drawing Rights and a Bank for International Settlements basket. The BIS-referenced gauge contains 40 currencies, while the SDR version has four.

Why now?

The Federal Reserve is widely expected to raise U.S. interest rates this week for the first time since 2006, a move that’s forecast to spur further gains in the greenback against the currencies of developing nations. The PBOC’s moves are being seen as part of efforts to ease concern about yuan depreciation and prepare the market for further weakness.

"Timing seems important" and it’s an attempt to cut the link with a strong dollar before the Fed tightens, Societe Generale SA strategists Jason Daw and Frances Cheung wrote in a note on Monday. "The PBOC is clearly preparing the market to interpret a weaker yuan versus the dollar not being devaluation."

Also, the International Monetary Fund voted to include the yuan in its Special Drawing Rights on Nov. 30, fulfilling a Chinese policy goal and giving Premier Li Keqiang scope to refocus his energies on helping revive growth in an economy expanding at the slowest pace since 1990. A weaker currency will help exports, which declined in all but two of the first 11 months of this year.

The idea of referencing the yuan to a basket of currencies isn’t new. In 2005, the PBOC said the yuan would be allowed to fluctuate against a basket of exchange rates. It just didn’t give any details of the composition and de facto pegs against the dollar during the 2008-2010 period as well as five months of this year suggested this wasn’t the case.

Yuan Implications?

It signals further depreciation against the greenback, according to yuan watchers including Goldman Sachs Group Inc., DBS Bank Ltd. and Daiwa Capital Markets. The PBOC statement is official confirmation that the currency is no longer pegged to the dollar, according to Daiwa, which has the most bearish view on the yuan with a forecast of a 14 percent decline to 7.50 versus the U.S. currency by end-2016. Goldman sees a drop to 6.60, which compares with the current spot rate of 6.4585 in Shanghai.

While the yuan has retreated 3.9 percent against the dollar this year, it has advanced against 12 of 16 major currencies tracked by Bloomberg, 

Referencing the yuan to several currencies doesn’t mean the exchange rate is pegged to that basket, according to an article on the PBOC website written by an unidentified commentator at CFETS.

Is This Unprecedented?

CFETS said its decision to publish its own exchange-rate index is in line with international practices, and that the Federal Reserve, European Central Bank and Bank of England have theirs as well. For example, the Fed’s trade-weighed real broad dollar index suggests the greenback rallied about 9 percent in the first 11 months of this year. The Monetary Authority of Singapore manages its currency against an undisclosed basket of exchange rates.

Bank of America said the latest statement is not an explicit shift to targeting the yuan against a basket of currencies, but an implicit attempt to manage market expectations.

Spillover Effect?

Further yuan weakness could spill over to other Asian currencies, according to Bank of America, which recommends keeping a close eye on the Japanese yen, Korean won, Taiwan dollar and Malaysian ringgit. CFETS may include the won and the Taiwan dollar in its new index when there are official reference rates for those currencies, according to Khoon Goh, Singapore-based strategist at Australia & New Zealand Banking Group Ltd.

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