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China's financial balancing act

The Chinese yuan moved closer to becoming a fully convertible international currency this month when the People's Bank of China (PBOC) doubled the daily trading band of the renminbi, as the currency is also called, to 2 per cent.

The timing was impeccable as it coincided with an announcement by the US Federal Reserve that its QE tapering would continue, alongside hints that US interest rates would rise more quickly than expected. The yuan therefore weakened rather than strengthened, as it might have done in different circumstances.

The wider band will generate more confidence in the currency and encourage market activity. It is rare, however, for a currency to move more than 1 per cent in a day. Last year, the yuan's largest one-day move against the dollar was just 0.21 per cent, so this step is part of a much bigger picture of market liberalisation.

The biggest non-market influence on the yuan tends to be the trading operations of the PBOC, so it is significant that a few days after the band was widened, the PBOC confirmed that the yuan's exchange rate would be increasingly determined by the market and that the central bank's decisive role in the yuan would weaken.

Since most PBOC activity over recent years has been trying to temper the strength of the yuan, naturally there is concern that market liberalisation could lead to a stronger currency. Despite regular interventions by the PBOC, the yuan has risen by about 30 per cent since 2005.

A good measure of the interventions is the accumulation of massive foreign reserves by the PBOC, which reached a record US$3.8 trillion last year - the world's largest. Last November, deputy governor Yi Gang said the PBOC no longer wished to add to its foreign currency reserves.

During the same week that the yuan band was widened, China added New Zealand to the small but growing list of countries able to trade directly in the yuan. Each new currency added increases the convertibility of the yuan and China is expected to continue heading rapidly down this path.

The PBOC also said it would focus on deposit-rate reform over the next two years. China's financial reforms, including the widening of the currency band and loosening of controls on interest rates, were praised by IMF Managing Director Christine Lagarde on a visit to Beijing last week. She pointed out that these reforms plus the opening up of the capital markets would help make China's financial system more resilient, strengthen the potential of the yuan as a global currency and diversify domestic savings.

China faces tremendous challenges in its financial reforms. There is intense pressure on the currency from capital inflows, and Beijing needs to dampen down speculation, control financial risk and keep the exchange rate at a competitive level while encouraging productive investment to maintain economic growth. This month's reforms can therefore be seen as a success in what is certainly a difficult balancing act.


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