A bank clerk counts dollar bills in Tancheng County, Shandong Province (XINHUA)

At 9 a.m. on August 11, 2015, the China Foreign Exchange Trade System (CFETS) announced the day's central parity rate of the yuan against the U.S. dollar, changing from the previous day's 6.1162 to 6.2298. The market burst into uproar over such a big drop of 1,136 basis points on a single day.

"All our traders were scared when seeing this rate, for we thought there must be something wrong with the system," a foreign exchange trader at a foreign-funded bank, who wished to remain anonymous, recalled in a recent interview with China Business News.

The People's Bank of China (PBOC), the nation's central bank, immediately issued an announcement saying that it had decided to improve the quotation of the central parity of the yuan against the U.S. dollar in order to enhance the market-orientation and benchmark status of the central parity.

However, within the following three days, the yuan's central parity rate weakened further by 3 percent, and a new round of yuan depreciation since the end of the previous year intensified criticism of the timing of the new round of exchange rate reform and the central bank's motives for depreciating the yuan.

The yuan's exchange rate has now depreciated more than 6 percent since the new exchange rate reform a year ago, but the market is not anxious despite such drops. A more market-oriented and more transparent central parity formation regime is being set up as exchange rate reform advances.

Ups and downs

"Since the reform of the foreign exchange rate formation mechanism in 2005, the yuan's central parity rate, which serves as the benchmark of China's exchange rate, has played an important role in market expectations and stabilizing the yuan exchange rate," said the PBOC in a press release on August 11, 2015. But last year, the yuan's central parity rate deviated from the market rate to a large extent and for a longer period, which to some level undermined the central parity rate's status and authority as a market benchmark.

"The foreign exchange market is developing in a sound manner, and market participants are increasingly strengthening their pricing and risk management capacities. The market expectation of the yuan's exchange rate is diverging, and the preconditions for improving quotation of the yuan's central parity are becoming mature," said the PBOC press release. All of these points laid foundations for the new exchange rate reform on August 11 of last year.

As a major part of the new exchange rate reform, improving the market makers' quotation will help enhance the market-orientation of the yuan's central parity rate, enlarging the operating room of the market rate and enabling the exchange rate to play a key role in adjusting foreign exchange demand and supply, according to the PBOC press release. Effective from August 11, 2015, the quotes of central parity that market makers report daily to the CFETS before the market opens should refer to the previous day's closing rate on the interbank foreign exchange market in conjunction with demand and supply conditions in the foreign exchange market and the exchange rate movements of major currencies.

"If the quotation methods were not changed, the deviation between the trading price and the central parity rate would continue to exist," said Guan Tao, a senior researcher with the China Finance 40 Forum, adding that improving the market makers' quotation will maintain the continuity and transparency of the yuan's pricing.

The yuan's exchange rate has experienced three rounds of depreciation and one round of appreciation within the past year.

Three days after the central parity rate reform, the yuan's exchange rate significantly dropped to 6.4 yuan against the U.S. dollar. On August 13, 2015, PBOC Assistant Governor Zhang Xiaohui said at a press conference that after two days of adjustment, the value of the yuan had gradually returned to market levels, and the 3-percent accumulated depreciation pressure had been released.

Between the end of December last year and early January this year, the yuan's central parity rate against the U.S. dollar dropped again, leading to fluctuations of the onshore and offshore exchange rates in Hong Kong. The central bank stabilized the yuan's exchange rate through measures such as changing the required reserve ratio of deposits of overseas financial institutions at domestic financial institutions.

The third round of depreciation happened between May and July this year, when market expectations for a rate hike by the U.S. Federal Reserve increased, and Britain voted to leave the European Union. The yuan's exchange rate experienced a slide of more than 2,000 basis points from 6.45 yuan against the U.S. dollar in early May to nearly 6.7 in late July.

But a round of appreciation soon followed. When the exchange rate approached 6.7 against the U.S. dollar, market expectations for the yuan's depreciation were alleviated, and 6.7 was also regarded by many industry insiders as the bottom line rate acceptable to the central bank in the short term. From the end of July to early August, the yuan appreciated remarkably against the U.S. dollar.

Reform continues

Challenges remain to maintain a stable exchange rate for the yuan, but since the August 11 central parity rate reform, the market has become better at anticipating the daily rate, and communication between the central bank and the market has become more timely and transparent.

"Managing a floating exchange rate regime is also a new challenge for the central bank," said Hu Yifan, chief China economist at UBS Wealth Management. "But through the central parity rate reform and the two rounds of significant exchange rate fluctuation, we can see that the central bank has become more experienced in management."

The yuan's exchange rate formation regime has gained the public's trust, said Zhu Haibin, chief China economist at JPMorgan Chase & Co. According to Zhu, the increase of public trust in the new exchange rate regime is due to the central bank improving communication with the market and its further strengthening of capital outflow controls.

Despite the pressure of U.S. dollar appreciation, PBOC Governor Zhou Xiaochuan still thinks there are no grounds for the yuan to further depreciate.

At a quarterly conference on July 4, he vowed to further advance the reform of the yuan's exchange rate formation regime and be flexible in the use of various monetary policy tools, aiming to keep the yuan basically stable at a reasonable and balanced level.

This year, China hasn't slowed down in advancing the reform of its foreign exchange market.

On June 24, a foreign exchange market self-discipline regime was established in Shanghai. Chen Siqing, Vice Governor of the PBOC, said that this regime is an important measure to improve the systems and institutions of the country's foreign exchange market, which will greatly elevate the yuan's status as a settlement and reserve currency and further accelerate the process for the yuan to become an international currency.

Copyedited by Chris Surtees

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