A cargo ship berths at a wharf of the Huanghua Port in north China’s Hebei Province on November 8, 2015 (XINHUA)

The year has started off with a nervous shudder of paranoia amidst steep market tumbles and the recent depreciation of the yuan against the U.S. dollar, raising doubts of the stability of China's financial market. Rest assured, the effective exchange rate of the yuan maintains stable, and there are a multitude of factors buttressing the Chinese currency in the medium and long term.

This is made evident according to a yuan exchange rate composite index released by the China Foreign Exchange Trade System (CFETS) on January 4. As of December 31, 2015, the CFETS yuan exchange rate index gained 0.94 percent from the end of 2014. In addition, compared to the end of 2014, the yuan exchange rate gained 1.71 percent against the Bank for International Settlements' currency basket and weakened by 1.16 percent against the IMF's Special Drawing Rights basket.

The mixed movements of the three indexes mirror the overall stability of the yuan exchange rate against a basket of currencies in 2015, as articulated by an article on the website of the People's Bank of China (PBOC).

"Though the yuan faces depreciating pressures this year, a steep decline of the yuan exchange rate against the U.S. dollar seems unlikely," He Liping, Dean of the Department of Finance at Beijing Normal University, told Beijing Review .

He thinks China is capable of pulling up the yuan through market intervention, since its central bank still has more than $3 trillion of foreign exchange reserves available--despite the reserve's monthly decline of a record $107.9 billion in December 2015. Independent economist Ma Guangyuan argued that the shrinkage is also a result of the central bank's interventions to stabilize the yuan exchange rate by unloading the foreign reserves.

On the other hand, He said that China's trade and current account balances still enjoy a huge surplus, which will bolster the yuan. He predicted that the yuan may depreciate by around 5 percent this year.

On the whole, China's current condition is favorable enough to maintain a relatively stable yuan exchange rate against a basket of currencies, said the PBOC article. The overall performance of the economy is basically stable, growth rate is within a medium-high range, and the economic structure is improving as reforms take hold.

Despite a slowdown in export growth, the share of China's exports to the global market actually expanded last year. In 2015, China registered a trade surplus of $594.5 billion. It doesn't need to boost its exports through competitive devaluations of the yuan, said the PBOC article.

Therefore, there is no basis for the yuan to continue depreciating, according to the PBOC. The bank attributed its confidence to the continual growth of China's inward and outward direct investments, the significant amount of foreign exchange reserves, the stability of its financial system, and increasing overseas demand for yuan-denominated assets. This year, the yuan exchange rate will continue to float in a two-way and flexible manner based on market demand and supply, with reference to a basket of currencies, concluded the article.

Root causes

Lian Ping, chief economist from the Bank of Communications, held that the exchange rate of a country's currency is primarily determined by the country's long-term economic fundamentals. Despite the current slowdown, China probably maintains a 7-percent-or-so growth pace, which is a pretty high score when compared to other countries, according to him.

"Though the strong dollar spurs a reflux of capital and imposes a downward pressure on the yuan, China's economic fundamentals and policy adjustment capability will shield the yuan from the dangers of a drastic slump," said Lian.

There are various reasons behind the current yuan devaluation against the U.S. dollar, explained He, who attributed them to the interest rate hike by the Federal Reserve (Fed) in the United States and bursting financial bubbles in China's domestic market.

"Since the Fed raised the interest rate last December, some domestic and overseas investors believed that dollar-denominated assets would witness a rise in return rates, leading to the relative weakening of other currencies," said He. Part of the larger picture is that the U.S. economy is still on the road to recovery with the U.S. dollar gaining strength, while conversely, China's economic growth is braking after having reached high speeds.

Additionally, since domestic assets became overpriced over the course of the past three to five years, some bubbles had formed in China's financial markets. Those bubbles have not been completely squeezed out, He noted. The foreign exchange market has also been affected by the pressure. Expectations for the yuan's depreciation had begun sprouting at the foreign exchange market since the beginning of last year, He said.

Short-term speculation also had a hand to play in the recent debacle. Some speculators attempted to make a fortune from hot money trading based on yuan wagers. Although such activities don't reflect the true market's supply and demand, it still sent the wrong price signals to the market, according to the PBOC article.

In fact, as early as last December, a trend composed of the yuan short selling had emerged. Complicated by the repeated downward adjustments of the yuan central parity in January, the expectation of the yuan's devaluation had become increasingly overwhelming. That encouraged a significant amount of unhealthy speculation throughout the global market, according to Xiao Lei, a research fellow from G-banker, an Internet financing platform focused on gold investment.

Ensuring stability

The recent depreciation of the yuan against the U.S. dollar--in contrast to a more stable CFETS yuan exchange rate index--raised the issue of the formation of the yuan's exchange rate.

Ma Jun, chief economist of the PBOC's research bureau, told the Chinese media that the yuan's exchange rate has already been unpegged from the U.S. dollar, though it's not floating freely.

"The yuan's exchange rate will be determined with more reference to a basket of currencies--that is to say, the yuan's value will basically be kept stable against the whole basket," said Ma. "That's the tone set for the yuan's exchange rate formation mechanism for the foreseeable future."

This mechanism could improve the stability of the yuan's value against the currency basket, while two-way fluctuations of the yuan against the U.S. dollar would be widened. "Changes to the yuan's exchange rate against the U.S. dollar would not be unidirectional," Ma stressed.

A transparent, credible, basket-based exchange rate formation mechanism can help stabilize market expectations, so that the central bank can reduce the frequency and scale of its interventions in the foreign exchange market, he said.

Ma believes that the depreciating pressure on the yuan will be eased and the short selling of the yuan will decline when investors fully understand the mechanism. By then, positive factors such as trade surplus and the yuan's higher interest rates compared to foreign currencies can play a greater role in the formation of the yuan's exchange rate.

Giving more consideration to a basket of currencies will not hurt China's autonomy in making monetary policies, and that the yuan's rate will not be strictly pegged to the basket, he added.

Milestones in the Yuan's Exchange Rate Reform

August 11, 2015: The PBOC improved the yuan's central parity rate formation system to better reflect the market changes in the exchange rate of the yuan against the U.S. dollar. Daily central parity quotes reported to the China Foreign Exchange Trade System before the market opens for the day should be based on three factors--the closing rate of the interbank foreign exchange market from the previous day, the supply and demand in the market, and the price movement of major currencies.

September 29, 2014: China started direct trading between the yuan and the euro on the interbank foreign exchange market.

June 18, 2014: China started direct trading between the yuan and the British pound on the interbank foreign exchange market.

March 18, 2014: China started direct trading between the yuan and the New Zealand dollar on the interbank foreign exchange market.

March 17, 2014: The yuan's exchange against the U.S. dollar was allowed to rise or fall by 2 percent from the central parity rate each trading day, up from the previous limit of 1 percent.

April 9, 2013: China started direct trading between the yuan and the Australian dollar on the interbank foreign exchange market.

May 29, 2012: China started direct trading between the yuan and the Japanese yen on the interbank foreign exchange market.

April 16, 2012: The yuan's exchange against the U.S. dollar was allowed to rise or fall by 1 percent from the central parity rate each trading day, up from the previous limit of 0.5 percent.

May 7, 2011: A total of 82 Russian banks set up yuan accounts.

April 26, 2011: A pilot program of cross-border trade settlements using the yuan was expanded across the country within the year, and continued progress was made in pushing forward the pilot program of cross-border yuan investment.

February 22, 2011: Deutsche Bank took the initiative to establish the first electronic platform for offshore yuan transactions, contributing to the development of the yuan as a settlement currency.

January 14, 2011: The PBOC allowed qualified domestic enterprises to use the yuan to invest directly in foreign countries.

December 15, 2010: The yuan started trading in Russia, becoming the Chinese currency's first overseas market.

November 22, 2010: China started direct trading between the yuan and the Russian ruble on the interbank foreign exchange market.

June 19, 2010: The PBOC announced that it would restart exchange rate reforms and enhance the elasticity of the yuan's exchange rate.

July 21, 2009: Four years since the exchange rate reform, the yuan had appreciated against the U.S. dollar by 21 percent.

April 8, 2009: Cross-border trade was allowed to be settled through the use of the Chinese currency on a trial basis in Shanghai and in four cities of Guangdong Province.

May 21, 2007: The yuan's exchange against the U.S. dollar was allowed to rise or fall by 0.5 percent from the central parity rate each trading day, from a previous limit of 0.3 percent.

July 21, 2005: China initiated reforms by de-pegging the yuan from the U.S. dollar. The PBOC said it had shifted to "a managed floating exchange rate based on market supply and demand, referenced against a basket of weighted currencies."

Copyedited by Bryan Michael Galvan

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