Yuan Basket Plan Gets Momentum as Singapore-Style Fix Floated

  • Former central bank adviser proposes 15% band on basket
  • Central bank unit pledges to increase yuan ``flexibility''

Would Devaluation Help or Hurt Yuan?

A proposal to fix the yuan’s quandary is gaining momentum among some economists.

QuickTake The People’s Currency

The plan, put forward by at least three analysts, calls for China to let the yuan fluctuate freely against a basket of currencies within a trading band. Outside the range -- which would be as narrow as 4 percent or as wide as 15 percent under different versions of the proposal -- the central bank will intervene in the market.

Similar to what Singapore has adopted, the plan could be China’s get-out-of-jail card after a slew of changes in its opaque currency policy since August whipsawed investors and cost the central bank more than $500 billion in reserves, said the economists, including a former central bank adviser and a visiting scholar from the International Monetary Fund.

Under the current system, the yuan is allowed to trade 2 percent above or below a reference rate versus the dollar set by the People’s Bank of China. Critics say that the regime fixates investors’ attention on the dollar-yuan exchange rate, even as the authorities aim to break its tie to the strengthening U.S. currency. The lack of transparency on how it sets the reference rate, or fixing, keeps investors guessing about the intentions of policy makers.

“They are sort of stuck, I don’t think the market knows what exactly the policy is,” Tamim Bayoumi, a senior fellow at Peterson Institute for International Economics and an economist at the IMF since 1988, said from Washington. “The proposal is one way out of that,” said Bayoumi, who pitched the idea in a blog in December, favoring a 4 percent trading band.

By targeting a broader range of currencies and a wider band, the proposed system attempts to give market forces more sway in determining the exchange rates, save foreign reserves while shifting investors’ focus away from the dollar and provide clarity on policy. The PBOC didn’t immediately reply to a fax seeking comment.

Chinese policy makers have been struggling to restore calm in the yuan since August when it revamped its currency system to make it more flexible.

While the authorities have repeatedly said they aim to keep the exchange rate stable against a basket of currencies even if it falls versus the dollar, they have had little success convincing investors. The onshore yuan’s 5.6 percent slide versus the dollar over the past six months fueled expectations for a further depreciation and boosted capital outflows.

To shore up the yuan, the central bank burnt through foreign reserves and tightened capital controls, reversing years of efforts of relaxation. Over the past three weeks, the yuan is essentially re-pegged at around 6.58 a dollar, even as traders stepped up bets on a weakening in the forwards market.

The yuan, which is freely traded overseas, fell 0.1 percent to 6.6378 per dollar as of 9:01 a.m. in New York, or 1 percent cheaper than the currency trading in Shanghai. The discount, the widest in three weeks, signals that foreign investors are reviving bets against the yuan.

The current approach is unsustainable as the central bank may deplete its $3.3 trillion in reserves shortly, according Yu Yongding, a former academic member of the PBOC’s monetary policy committee.

Instead, the authorities should target the yuan against a currency basket with an adjustable reference rate and a trading band of 7.5 percent or even 15 percent, Yu wrote on Jan. 27 in an opinion piece on Project Syndicate, a website.

Market Mechanisms

Under such a regime, market forces will balance out the supply and demand for the yuan within the band, free of central bank intervention. Investors might start purchasing the currency before the exchange rate reaches the limit of the trading range, if they judge that it has fallen enough to reflect economic fundamentals, he said. With China having a large current-account surplus, the yuan won’t fall too far for too long, according to Yu.

On Monday, policy makers signaled the possibility of further reforms in its currency system. The government will increase the “flexibility” of the yuan against a basket as it continues to improve its market-oriented exchange-rate mechanism, China Foreign Exchange Trade System, a central bank unit, said in a statement.

New Index

That announcement came less than two months after the unit unveiled an index tracking the yuan against 13 major currencies, fueling speculation the government may start to use it as a reference to manage the exchange rates. The index ended January at 100.15, down 0.8 percent from December, but it is little changed since the end of 2014, in line with the government’s claim that it aims to create stability.

Monday’s statement “could represent an important signal about how the government hopes to manage the yuan” after the local markets reopen following a week-long Lunar New Year holiday starting Feb. 8, analysts at Credit Suisse Group AG wrote in a note Tuesday.

Other analysts are skeptical.

Targeting the basket is difficult because the yuan’s movement in itself could feed into the fluctuations of a broad range of exchange rates, creating the risk of a depreciation spiral, said Qi Gao, a Hong Kong-based strategist at Scotiabank.

Singapore’s System

Currency traders are expecting policy makers to loosen their control over the yuan. One-year implied volatility on the onshore yuan, which reflects investor expectations for future currency swings, jumped to 10.45 percent on Wednesday, the highest since 2009, surpassing that of the Singapore dollar, the euro and yen, according to data compiled by Bloomberg.

A step toward a free-float system, the proposal from the economists has some of the features of Singapore’s "basket, band and crawl” system. Since the 1980s, the Singaporean authorities have managed the local dollar against an undisclosed basket of currencies and guided monetary policy through exchange rates. The currency is allowed to float within an adjustable band with undisclosed width.

Unlike Singapore, China can be more transparent about its system to re-assure investors by disclosing the basket and it can maintain an independent monetary policy with a more flexible exchange rate, said Bayoumi.

China’s current approach of tightening capital controls and heavy intervention is against its long-term objective of opening markets, he said.

“It’s odd to choose policies that move against your ultimate objectives,” according to Bayoumi. By adopting the proposal, “you are moving toward your objectives, while solving your immediate problems,” said Bayoumi.

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