China's small step towards currency reform

STARTING Monday, the Chinese yuan's trading band has been doubled from one per cent to two per cent on either side of the so-called parity rate which is set by the People's Bank of China (PBOC), the country's central bank, as a peg against the US dollar. This is a welcome move that amounts to another step - albeit a small one - in China's long journey of financial reform. However, there will, and should, be more to come.

The widening of the band within which the Chinese currency is permitted to move was well anticipated. In a statement on February, the PBOC had indicated that one of its policy goals was an "orderly" widening of the yuan's trading band. Currency markets responded by sending the yuan lower against the US dollar. This is no bad thing: A weakening of the yuan drives home the point that China's currency is not a one-way bet. Some people had assumed it could only go up, which had led to surging capital inflows, both in terms of hot money and foreign direct investment. These in turn added to the credit bubble in China, which the PBOC is trying hard to curb. Making the yuan a two-way bet is one way to do this. A weaker yuan - which is the likely short-term impact of a wider band - could also benefit the economy in other ways. It could raise inflation a notch, which would be good for consumer spending, which the Chinese government is trying to encourage. It would also help boost exports. Although the PBOC as well as most analysts suggest, correctly, that this was not a motive in the decision to widen the band, it could be a useful side-effect. China's growth is slowing. Many analysts forecast that even the 7.5 per cent GDP (gross domestic product) growth target for this year will be hard to meet. Investment growth is also slowing, and consumer spending will be slow to take off. In these circumstances, any help China can get from exports would be welcome. Moreover, with its biggest markets, the United States and the European Union, now in recovery mode, this is not a bad time for China to have a more competitive currency.

The PBOC could, however, have been more aggressive in widening the band, going to at least 2.5 per cent on either side. While the urge to be cautious is understandable, it should be noted that this is not the first time the yuan's trading band has been widened. It also happened in April 2012 when it was widened from 0.5 per cent to one per cent on either side of the parity rate. That did not create any instability. Hopefully, the band will be further widened from here, which would make the yuan a more flexible currency and even less of a one-way bet - albeit most analysts project that in the long run it will strengthen against the US dollar. However in the long run, another reform that the PBOC should consider is a currency that is not pegged to the greenback, not even via a soft peg; as China trades with multiple countries, it should consider pegging its currency to a trade-weighted basket, which would better reflect its true value.