China needs to continue exchange rate reforms despite trade conflict with US

The yuan softened again on Thursday. Amid escalating trade friction with the US, China needs to show greater tolerance for foreign exchange market volatility, if the depreciation is a reflection of market supply and demand.

The onshore yuan weakened past the psychologically important 6.7 per US dollar level during Thursday’s morning session, after the People’s Bank of China, the central bank, set the daily reference rate at 6.6726, its weakest level since August 2017.

The fall in the yuan came as Sino-US trade friction intensified, with some investors hoping the government will intervene to maintain the stability of the currency. However, that is not the only choice China has.

The external economic environment is increasingly unfavorable.

A moderate depreciation of the yuan is unavoidable. Foreign exchange market volatility must be tolerated under exceptional circumstances, such as the ongoing trade conflict.

A market-driven depreciation will benefit the nation’s exports and serve as an automatic economic stabilizer.

As long as there is no sign of panic in the market, the Chinese government is unlikely to take action against the weakening of the yuan.

We have yet to see evidence that global short-sellers are taking this opportunity to boost bearish bets against the yuan.

Most domestic traders are expecting the onshore yuan to swing in a range between 6.7 and 6.8 per US dollar. China has yet to face a crisis that would require the central bank to intervene.

A key concern is that depreciation will spark a new round of capital outflows, creating a vicious cycle in the Chinese economy, but that has not yet taken place.

Despite gradual depreciation of the yuan, the impact on China’s macroeconomy has been limited.

At present, the best choice is to be prudent about intervention the foreign exchange market, and allow the exchange rate to move naturally.

Thanks to China’s ample foreign exchange reserves, it’s easy to stop the depreciation of the yuan.

What is more difficult is to widen the range of exchange rate fluctuations and continue reforms to make the yuan’s exchange rate more market-driven despite depreciation pressures caused by trade friction.