News Analysis: Yuan more market-oriented after reform

A reform to the yuan's exchange rate formation system has made the currency more market-oriented and helped stabilize expectations.

On Aug. 11, 2015, the People's Bank of China (PBOC) announced a major improvement to the formation of the yuan's central parity rate against the U.S. dollar by taking into consideration the closing rate on the inter-bank forex market of the previous day.

The move was described by the PBOC as a "one-off" adjustment, which bridged previously accumulated differences between the central parity rate and the spot market rate, as the deviation undermined "the authority and the benchmark status" of the central parity system.

During the decade before, the central parity rate of the yuan against the dollar was decided by a weighted average of prices offered by market makers based on demand and supply and the rates of a basket of major currencies, which were sometimes insufficient to reflect real market situations.

From March 2014, the yuan is allowed to rise or fall by 2 percent from the central parity rate each trading day.

Over the past year, the yuan's central parity rate against the U.S. dollar weakened from 6.1162 to 6.6255 on Thursday, with the yuan depreciating by 7.69 percent.

The reform brought the central parity rate one step closer to real market situations, as it has generally been equal to the inter-bank market closing rate ever since, analysts say.

"The PBOC has actually abandoned the management of the yuan's central parity rate against the dollar," said Xiao Lisheng, a financial expert with the Chinese Academy of Social Sciences.

The central parity rate formation system based on "closing rates and rate changes of a basket of currencies" is more flexible, transparent and market-oriented than before, and helps keep expectations steady, the central bank said in a quarterly report last week.

All market makers, including Chinese and foreign commercial banks, follow the same standards in offering their own quotes for forming the central parity rate. The rate is highly predictable for most market participants, although there are subtle differences in their detailed calculation criteria.

Meanwhile, as the U.S. dollar's trend is uncertain, reference to a basket of currencies helps avoid expectations for a one-way depreciation or appreciation and thus reduces speculation.

For instance, after the Brexit vote late June, the yuan saw sharp depreciation against the dollar due to the strength of dollar as investors sought to avert risk.

With the market playing a bigger role in rate formation, expectation of further yuan depreciation has weakened, said Wang Chunying, spokesman for the State Administration of Foreign Exchange.

However, the improved mechanism is far from perfect, as it is transitional one being used before the forming a fully market-based system.

"The yuan's exchange rate still lacks flexibility," Xiao said.

In the future, the country needs to continue reforming the formation mechanism toward a market-based direction.

"As a large nation, a freely floating currency should be the ultimate goal of China's reform," Xiao said.

China has strongly promoted the global use of its currency, as the world's largest trading nation looks to lower transaction costs in international trade, which currently is mostly settled in U.S. dollars.

In November 2015, the IMF announced that the yuan met the criterion of a freely usable currency and would be included in the SDR basket from Oct. 1, 2016. Endi