Foreign Exchange Reform – Unfinished Business
Since the unification of its exchange rates in 1994,China has employed a managed floating exchange rate mechanism that is based on supply and demand. On August 11,2015,a new pricing mechanism was put in place to set the mid-rate (also known as the parity rate) for the renminbi against the US dollar. This was aimed at creating a more market-based exchange rate. The exchange rate reform has now been in place for over a year,achieving the preliminary goal of attaining a more market-driven mid-rate. The renminbi trades around that daily mid-rate and which guards against shocks from big movements of capital. However,the effort to make the renminbi exchange rate fully market-driven is still a work in progress and deeper reforms are needed.
Major Outcome of 2015 Forex Reform
The reform introduced on August 11,2015 stated that the mid or parity rate set each day between the renminbi and the US dollar would take the closing exchange rate of the previous trading day as a "reference." The market rate trades around that mid-rate,reflecting changes in supply and demand,but within a limited band.
On December 11,2015,the renminbi exchange rate index was unveiled by the China Foreign Exchange Trading System. It measured the renminbi against a basket of currencies and was designed to serve as a benchmark to help maintain a stable exchange rate between the renminbi and this group of currencies. In February of this year,based on discussions with 14 market makers,the central bank launched the pricing mechanism which is now in effect. The mid-rate between the renminbi and the US dollar would be determined by using the closing market price of the previous trading day and the change in the exchange rate against the basket of currencies as well. According to banking sources,under the new pricing mechanism,the gap between the mid-rate and the average quotes from banks participating in the interbank market has narrowed,showing further progress in achieving market-based pricing as well as transparency. Under present conditions,this pricing mechanism is focused on the goal of stabilizing market expectations and increasing exchange rate flexibility,guarding against risks while promoting reform.
Enhancing the Benchmark Status of Mid-rate
Before the exchange rate reform last year,the domestic market rate for the renminbi against the US dollar was depreciating over a fairly long period of time and moving a considerable distance from the mid-rate each day. As a result,the mid-rate was not of great value. If the allowable daily trading range were expanded,the market rate would continue to deviate from the mid-rate,and it was not inconceivable that there would be a difference of over 2%. This could lead to what would effectively be a dual exchange rate,and that would violate the general obligations under Item 8 of the Agreement of the International Monetary Fund. After the August 11 reform,there was a narrowing of the gap between the market price and the mid-rate,and the gap between the opening price and the mid-rate. Moreover,the market rate and the opening price fluctuated around the mid-rate. From the reform in August 2015 until June 2016,the biggest daily fluctuation between the market rate for the renminbi against the US dollar among banks and the mid-rate was only 0.22%,far lower than 1.53% in the months before the reform. This shows that the reform has allowed a more accurate reflection of market information.
The speed between the onshore and the offshore renminbi rate toward to narrow. Influenced by the renminbi's depreciation,from the date of the exchange rate reform to the end of that year,the average daily price difference on the onshore and offshore markets was 440 basis points. At times it was as much as 1,000 basis points. This year the average daily difference between the onshore and offshore rates narrowed to 161 basis points,reflecting the improved sentiment toward the renminbi and demonstrating the reduced room for arbitrage between the two markets. Meanwhile,the narrower gap between the onshore and offshore rates also removed an obstacle in calculating the value of the renminbi once it is added to the IMF's Special Drawing Rights,a basket of reserve currencies,in October this year.
The central bank's communication with the market is improving. Market expectations have a significant impact on cross-border capital flows and the movement of the renminbi's trading rate. The 2015 reform was a big test of the central bank's ability to manage market expectations. In the first four months of 2016 the renminbi held steady against the dollar before starting to fall again in May. However,unlike in the past,this did not shock the markets. It showed that the market realized the adjustment in the renminbi exchange rate was mainly a reflection of the strengthening US dollar,which was buoyed by expectations of interest rate increases by the US Federal Reserve and concerns over Britain's referendum on its participation in the European Union. It was not seen as a competitive devaluation of the Chinese currency by Beijing.
On July 21,officials of the US Treasury Department stated that the fall in the renminbi was not driven by Beijing and that China was actually trying to halt a further depreciation of its currency. In June,the onshore renminbi exchange rate (referred to by the market as CNY) exceeded 6.60 and even touched 6.70 to the dollar,but foreign exchange reserves actually rose that month by US$13.4 billion (after falling US$27.9 billion in May). In June,the foreign exchange reserves of the central bank declined by 97.7 billion yuan,more than the average monthly reduction of over 50 billion yuan in the previous two months,but far less than the average monthly decline of 339.1 billion yuan in the first quarter. Communication with the market and the management of market expectations was shown to be effective and as a result,won high praise internationally.
Foreign Exchange Market Further Developed
Although there have been further shocks to the domestic foreign exchange market since the reform,there has been no let-up in the steady development of the market's framework. China has continued to open the domestic interbank market and make it easier for foreign institutions to participate in foreign exchange business and hedge their exchange risks. It has made efforts to support the new requirements for the renminbi with its inclusion in the IMF's Special Drawing Rights,expanding the trading channels of the offshore and onshore markets and extending the onshore trading hours,allowing onshore and offshore rates to be even more aligned. It has posted more foreign exchange reference rates,promoting efficiency in forming market rates and aiding risk management and financial settlement. This has upgraded regulation and promoted an orderly market.
Capital Account Liberalization Taking New Step
In keeping with developments in cross-border capital movements,there have been relaxations of rules on capital inflows and outflows in some areas though the emphasis has been on inflows. There has already has been the cross-recognition between the domestic market and Hong Kong for mutual fund investments,a further opening of the domestic interbank bond market and a simplification of some foreign exchange rules for qualified foreign institutions. Additionally,there has been a formal inauguration of the first phase of the Cross-Border Interbank Payment System (CIPS),a launching of studies on linking the Shenzhen and Hong Kong stock markets and a Shanghai-London stock link as well as a relaxing of curbs on foreign debt. In 2015,there were 37 items under the capital account that were considered at least partly convertible. The three non-convertible items are securities such as stocks issued domestically by non-residents in China,currency market instruments issued by non-residents in China,and derivatives and other instruments issued by non-residents in China. Compared with the 72.5% level of convertible transactions in 2009,it is a great leap forward.
In late 2015,the IMF decided that the renminbi could be considered as a "freely usable" currency and therefore qualified for inclusion in the SDR basket of currencies. It is an affirmation of China's reform of the renminbi exchange rate system and the progress in international convertibility for the renminbi. Shortly after Britain voted to leave the EU,a move that unnerved markets,China's Ministry of Finance successfully sold 14 billion yuan of government bonds,demonstrating the attractiveness of renminbi assets,particularly those with relatively high yields at a time of generally low yields on international markets.
In the past,with the renminbi convertible for current account items and pressure growing from capital outflows,China strengthened its authenticity verification on current account items through its Online Verification System of Customs Declarations for Imports and Exports. This plugg