To free market, with the yuan

Yuan appreciation this time is singularly free of the usual high- decibel paranoia of ‘ hot money’ flowing into China

BEIJING

Something unique is happening in China. Market forces are being allowed to prevail in the functioning of the yuan and there is a distinct likelihood that the Chinese currency may become more free and flexible in the near future.

The exchange rate of the yuan, or renminbi as it is known, hit a record high on October 26, going up to 6.24 yuan against the US dollar - its strongest level in 19 years. This came close on the heels of a bullish currency trend in September – a month which saw the largest jump in capital inflows since the beginning of the year. China experts are optimistic that the yuan could climb to 6.19 per dollar by the end of 2013.

Yuan appreciation this time is singularly free of the usual high-decibel paranoia of ‘hot money’ flowing into China. The recent hike in the yuan against the dollar was mainly because the People’s Bank of China (PBOC) didn’t sell the yuan and purchase foreign currency, as is the practice. Previously, with a large balance of payments surplus, China’s central bank had to intervene massively to prevent market pressures from driving the yuan up sharply. This surplus has come down recently, as China has increased its imports. Therefore, at the moment, it can allow the currency to be determined largely by market forces without setting off a sharp appreciation that may badly hurt exports.

This altered set of circumstances could well be a precursor to the next step in financial and monetary reform as ultraconservative policymakers signal that the country’s economy and financial system are robust enough to withstand further flexibility in the exchange rate.

Money market experts strongly feel that it is time for PBOC to reduce intervention in the currency markets and let the yuan float freely. Circumstances have changed radically. It is easier for policymakers now to allow market pressures to operate in the foreign exchange market than it was during a heavily export-driven economy.

So why is the renminbi appreciat- ing, and why is China not getting upset about the trend? A careful monetary policy, a stabilised Chinese economy and third round of quantitative easing in the United States has led to the strengthening of the yuan and is likely to continue in the short-term.

China’s economy, according to the National Bureau of Statistics, expanded by 7.7 percent year on year in the first three quarters, higher than the 7.5 percent annual economic growth target set for 2012. Signs of economic stabilization are now apparent to the world, encouraging overseas capital to enter China.

Across the seas, the US Federal Reserve extended the duration of its ultralow interest rates to bolster its own weak economic recovery. Differences in investment returns, interest rates and exchange rates are now the determining factors for international capital to enter China.

Yuan holdings among banks for purchasing foreign exchange, a key measure of capital flows, rose 130.7 billion to 25.8 trillion yuan in September. As major economies stabilize and capital continues to flow into emerging countries, yuan holdings for purchasing foreign exchange would continue to grow in the next few months. The buzz that the recent yuan strength has mainly been driven by market forces like capital flows, as opposed to tweaking by the central bank has generated a lot of optimism.

In the last two months of this year, the government may send a strong signal that the yuan will be further liberalized and will be more market driven. The PBOC may allow more flexibility and broaden the permitted fluctuation limits of the currency. Since April, the central bank had allowed the yuan to fluctuate by 1 percent from the artificially set daily mid-point and economists now expect that fluctuation limits can be extended from the current 1 percent to 2.5 percent after two mega political events – the US presidential elections and the 18th National Congress of the Communist Party of China – get over. With this inherent strength, the yuan has already begun to establish itself as the Asia Pacific’s regional reference currency.