China Headlines: All you need to know about China's new FX policy

When China's central bank unexpectedly adjusted its yuan central parity system, it triggered the currency's biggest decline for decades.

So, what exactly happened?

On Tuesday, the People's Bank of China (PBOC) changed the way it calculated the yuan central parity rate, to close the gap between the rate and the actual trading rate on the money markets.

From Tuesday, the central parity rate has taken into account the previous day's inter-bank market closing rate, supply and demand in the market and price movements of other major currencies.

Ma Jun, a central bank economist, described the change to the way the central parity rate is calculated as a "one-off" technical correction that should not be seen as the beginning of a devaluation trend.

Just what is the central parity rate?

Each trading day at 9:15 a.m. Beijing time, the central parity rates of the yuan are announced against 11 major currencies including the euro, sterling, U.S. dollar and yen. The rates are determined by a weighted average of pre-opening prices offered by market makers. When the inter-bank FX market opens 15 minutes later, trading may only take place within 2 percent of the rate.

Why now?

The U.S. dollar is strong and a sharp appreciation in the real yuan rate has hit China's exports hard. The figures for July slumped by 8 percent. Furthermore, the central parity rate has gradually deviated from the market rate "by a large amount and for a long duration," according to the PBOC, which has undermined "the authority and the benchmark status" of the central parity system.

How did markets react?

On Wednesday, the yuan declined sharply for the second day in a row, leading to a heavy sell-off in regional currencies and raising concern worldwide that volatility will become a drag on global economic growth.

Asian stocks fell.

The yuan is expected to remain weak and volatile in the near term.

Is this a deliberate move to stimulate exports?

Tuesday's move is regarded as another step towards allowing market forces to determine the value of the yuan, but is probably not enough to make much difference to either exporters or China's trade partners.

HSBC say the move does not mean that China has begun to purposely devalue the yuan.

"In an environment of soft global recovery, the benefits of beggar-thy-neighbor competitive devaluation are neither clear nor easy to reap," was the bank's analysis of the situation.

How will this affect the Chinese people?

A weaker yuan makes imported products more expensive and foreign travel more costly.

The Chinese are just getting used to their new prosperity. Shopping has become very important to them, especially shopping for imported goods. Foreign travel for its own sake, but more specifically for shopping, is central to the aspirations of China's new wealthy classes. Those who plan to study abroad, particularly at American schools, will also feel the pinch.

Is all this good or bad for the yuan's chances of a quick inclusion in SDR?

The International Monetary Fund (IMF) has welcomed the reform, which will certainly raise the prospects for the yuan becoming part of the IMF special drawing rights (SDR) currency basket sooner rather than later.

The change does not directly affect the push for SDR inclusion, but an IMF spokesman said on Wednesday that "a more market-determined exchange rate would facilitate SDR operations in case the yuan was included in the currency basket."

What's the risk?

The depreciation might trigger capital flight, dealing a blow to the stability of China's financial system. Bloomberg economists Fielding Chen and Tom Orlik reckon that a 1-percent depreciation against the dollar will suck 40 billion U.S. dollars out of China. While 40 billion U.S. dollars is certainly not chicken feed, with massive foreign exchange reserves, substantial bank deposits and a controlled capital account, China is well set to deal with such an eventuality.

So, what next?

The PBOC has promised more FX reform along the lines of "market- orientation" and opening up the FX market. More foreign entities are being allowed to participate in China's financial markets, and the onshore-offshore yuan exchange rate will gradually be unified. Endi