Global traders have little to fear in hints of a freer yuan

[HONG KONG] When China blindsided traders in August 2015 with the steepest yuan devaluation on record, the reaction in global markets was swift and painful: Emerging-market equities collapsed into a bear market, oil plunged and the S&P 500 Index began a slide that would spiral into its worst month in three years.

But these days, a flurry of speeches and commentaries on the need for a freer yuan - some of which suggested widening its trading band - have caused barely a ripple. That's because the People's Bank of China has already succeeded in taming the market: thanks to suspected intervention and stricter capital controls, the spot rate has rarely moved more than 0.5 per cent on either side of the fixing, well within the 2 per cent daily limit.

With a much steadier economy and financial markets, China faces a choice of returning to its commitment to freeing the currency, or keeping a tight grip to minimise risks ahead of a key political leadership shuffle in the fall. Fulfilling repeated pledges to ease exchange-rate controls would help the country retain monetary independence and open up its capital account - while risking quicker declines in the yuan.

"Widening the band is a cheap way for them to be seen as delivering exchange-rate reforms without doing a lot," said Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong. "I don't think we should kid ourselves that any widening of the band would represent any kind of exchange-rate liberalisation. The reality is that China maintains tight control over the exchange rate."

The time is right for the currency to be allowed greater flexibility because the market is stable, the China Securities Journal said in a front page commentary on Tuesday, while PBOC Assistant Governor Zhang Xiaohui wrote Monday that the nation will let the market play a more decisive role. A newspaper run by the central bank laid out the steps needed for further reforms in a July 12 report that included potentially widening the trading band.

Since making the fixing more market-driven in August 2015, a vicious cycle of capital outflows and speculative selling has prompted policy makers to tighten control. They have restricted outflows, pushed up offshore yuan rates, intervened in the market occasionally, and, most recently, tweaked the reference rate mechanism.

All these moves, along with a weaker greenback, have put the yuan on course for its first annual gain since 2013. It has strengthened 0.9 per cent this quarter to 6.7223 per US dollar, extending its advance for the year to 3.3 per cent. The spot rate is now 0.03 per cent weaker than the fixing, compared with an average 0.9 per cent in the year leading up to the 2015 devaluation. The yuan's trading range was last expanded in March 2014 from 1 per cent, and before that doubled from 0.5 per cent in April 2012. The limit was 0.3 per cent ahead of an adjustment in May 2007.

National Australia Bank strategists led by Christy Tan wrote in a note in mid-July that greater flexibility should first be about allowing more volatility within the current 2 per cent range. Bank of America Merrill Lynch's Claudio Piron said in a note last week that increasing the band could make the yuan vulnerable to bigger declines in case US-China trade tensions escalate.

Tuesday's Securities Journal article stressed that this was a good time to boost flexibility because volatility may rise again. "The yuan won't keep remaining steady," it read. "The current pricing mechanism and other measures are just temporary, transitional tactics to buy time for the market to adapt to greater flexibility."

Any move to increase the range will likely be preceded by more supportive commentary in the media, said Gao Qi, a Singapore-based strategist at Scotiabank. He wrote in a note Wednesday that recent comments in state press and by officials have "markedly raised the odds of a band widening over the remainder of the year."

RBC's Ms Trinh said in a July 21 note that an unchanged band over the coming months would reinforce concerns over a lack of consensus in the leadership and suggest that calls for widening were criticisms against the current currency policy.

"What we really need are policies that support a widening trading band - that is, market-friendly reform," said Axel Merk, president of Merk Investments LLC in San Francisco. "We see China taking as many steps forward as they take backward."

BLOOMBERG