News Analysis: China seeks to sustain RMB stability against basket of currencies amid U.S. rate hike cycle

China will seek to maintain the country's currency renminbi (RMB), or the yuan, relative stable to a basket of currencies in 2016 as investors adjust to the start of a new rate hike cycle in the United States, U.S. experts said.

The U.S. Federal Reserve raised its benchmark interest rates to a range of 0.25 percent to 0.5 percent on Dec. 16 of 2015, the first rate hike in nearly a decade, marking the end of the central bank's extraordinary monetary easing measures in response to the recent global financial crisis and the beginning of a new era of a Fed tightening cycle.

While the Fed's initial rate hike was welcomed in the United States as the central bank is confidence about the underlying strength of the world's largest economy, it poses challenges for emerging market economies like China to balance currency stability with economic growth.

The divergence of monetary policies between the U.S. and other major economies has driven investment flows into the U.S. and pushed the U.S. dollar higher against most major currencies around the world.

The Fed's anticipated more rate hikes in the coming year will further increase attractiveness of the greenback and put downward pressure on emerging market currencies. The central parity rate of the RMB has weakened to the lowest in more than four years against the dollar in recent weeks.

The People's Bank of China (PBOC), China's central bank, said Monday that it will keep the RMB exchange rate basically stable at a reasonable and balanced level as it seeks to maintain a prudent monetary policy and continue the market-determined exchange rate reform.

"I think Chinese policymakers would like the environment to be stable. They don't want to have any abrupt movements in the currency that could be destabilized," Charles Collyns, managing director and chief economist at the Institute of International Finance (IIF), told Xinhua in a recent interview.

"If the market comes to think that the RMB is going to be very weak, then you could have very strong capital outflows that would require interventions by the PBOC," he said.

China's foreign exchange reserves fell by 87.2 billion dollars to 3.43 trillion in November of 2015, the lowest level since early 2013, suggesting that an exodus of capital was occurring ahead of a widely-expected Fed's rate hike on Dec. 16.

Collyns said it's "a smart move" for China to release the CFETS RMB Index, a RMB exchange rate composite index that measures the currency's value relative to a basket of other currencies, on Dec. 11, a few days before the Fed's decision to raise interest rates.

The new index, released by China Foreign Exchange Trade System (CFETS), is calculated by comparing RMB to the average value of the 13 foreign currencies, including the U.S. dollar, euro and Japanese yen, weighted according to the trade volume with China.

In explaining the reason for the index, the PBOC said it "will help guide market participants to shift their focus from the bilateral RMB/USD exchange rate to the effective exchange rate, which is based on a basket of currencies."

The PBOC noted that valuing against a basket of currencies does not mean a peg to the basket, but it "will contribute to maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level."

"I think now they can argue that, look, we're managing against a basket of currencies, we're going to keep the currency broadly stable relative to the basket," Collyns said, adding that this strategy would involve a degree of depreciation against the dollar and some appreciation against other currencies like the euro and yen.

"That gives the Chinese policymakers more flexibility, because if the dollar appreciates against the euro, the RMB doesn't have to appreciate fully with the U.S. dollar," Collyns explained, warning that pegging to a strengthening dollar would cause further loss of competitiveness for China and hurt the exports.

While the RMB has depreciated against the dollar by roughly 4 percent since the beginning of this year, it has actually appreciated by 0.87 percent against a basket of currencies as of Dec. 25, compared with the end of 2014, according to the CFETS RMB Index.

"I think it helps to avoid some of the concerns that occurred this year when people were worried the RMB depreciated quite rapidly against the U.S. dollar, they lost the anchor for expectations about the exchange rates," said Collyns, a former assistant secretary for international finance at U.S. Treasury. "I think the PBOC now establishes a new anchor, which will be helpful to stabilize the expectations."

"China's exchange rate will no longer be dragged upwards against all other currencies by a rising dollar. But it is still likely to broadly stable against the world as a whole," Gavyn Davies, former chief economist of Goldman Sachs and now chairman of Fulcrum Asset Management, echoed Collyns's views.

"Basically we see a broadly stable effective rate fluctuating around a rate of about 102.5 (using the authorities' suggested base of 30 December 2014=100). The margins around this rate seem to be about 2.5 percent either way," Davies wrote in an analysis on his Financial Times blog, referring to the CFETS RMB Index.

Tamim Bayoumi, senior fellow at the Peterson Institute for International Economics, a Washing D.C.-based think tank, encouraged China to take bold steps to formally announce a new exchange rate regime linking to a new basket, which would be in the interests of both China and the international monetary system.

"Making the bold move of linking to the new basket published by the CFETS with a wider intervention band provides the potential for a smooth switch from the current system to one where one-way bets are less obvious, incentives to overborrow in dollars are curtailed, and renminbi markets are encouraged," Bayoumi wrote in a recent article published on the institute's website.

While moving towards a basket of currencies was probably the best thing for China, there was "a very significant psychological problem", said Pieter P. Bottelier, a senior adjunct professor of China studies at the School of Advanced International Studies of the Johns Hopkins University.

"We have to assume that in the minds of people running capital markets, the RMB-dollar exchange rate will remain very important," Bottelier told Xinhua in a separate interview, noting that the RMB's bilateral exchange rate against the dollar will continue to be one of the most closely watched indicators.

Bottelier said "there is an additional reason to be careful with the dollar exchange rate", given the fact the RMB was approved by the International Monetary Fund (IMF) to join its Special Drawing Rights (SDR) basket as a fifth reserve currency, along with the dollar, euro, pound sterling and yen, on Nov. 30, 2015.

"That's what everybody will be looking at, including U.S. Congress," said Bottelier, who served as chief of the World Bank mission in Beijing during the 1990s. "For the next year or two, you have to be very careful with the RMB-dollar exchange rate. It's probably better trying to preserve relative stability."

Bottelier believed the Fed's rate hike was potentially "a good thing" for China as it would help push forward China's financial reforms.

"With the Fed beginning to raise the interest rates and Chinese central bank trying to lower them, it's possible that at some point in the next year or two the domestic interest rates in China and international rates will be above the same level," Bottelier said. "Once you have that, it becomes possible for China to completely open the capital account and go to completely convertible capital system."

The PBOC approved RMB convertibility on the capital account within a prescribed limit of 10 million dollars for the Tianjin, Guangdong and Fujian free trade zones on Dec. 11, a historic step by China to open up its capital accounts.

Bottelier said China should be cautious and not in a hurry to complete open the capital account because of the risks of huge capital inflows or outflows, which are potentially disruptive. In his view, "it's probably in China's interests to retain at least some controls" on the capital account in the end. Enditem