RMB downturn in line with reform agenda

Weakened yuan inevitable given previous gains, financial system goals

Extending a decline that started in late 2014, the Chinese yuan has been steadily weakening against the US dollar since the beginning of the year, a trend not seen since the introduction of exchange rate reforms in 2005.

The currency's central parity rate, an official guidance rate set by the People's Bank of China (PBOC) which typically decides the daily direction, has been generally on a slide this year, with the spot yuan frequently approaching the 2 percent lower limit of its daily trading band against the greenback in the country's foreign exchange market. For instance, on February 17, the last trading day in the Year of the Horse, while the central bank weakened the renminbi by 57 basis points to 6.1330 per dollar, the yuan's spot price still fell to close at 6.2551, just shy of its daily downward limit of 6.2556.

To a certain extent, rising volatility in the currency market, along with deviations between the spot-yuan price and its reference rate, has fueled widespread expectations of further depreciation for the renminbi. Amid concerns over mounting turbulence in financial markets, some experts believe that a steady currency would benefit China's economic transformation and help avoid large scale capital outflows, so the central bank should not allow the yuan to continue its slide.

Yet, the recent weakness in the currency is nothing to fuss over. In fact, it only shows central authorities' reversal of expectations for unilateral appreciation in the yuan. With the central bank still guiding the yuan, its recent performance is not only in line with the market environment but also what China's financial reforms require.

Specifically, international and domestic factors have and will continue to weigh on the yuan. For starters, the strengthening US dollar as well as monetary policies in Europe have exerted major pressure on the Chinese currency. As Pan Gongsheng, deputy governor of the PBOC, remarked in January, "a dollar bolstered by quantitative easing in Europe and monetary policy normalization in the US would deflate the renminbi's exchange rate."

Moreover, the yuan also faces pressure from the country's lackluster real economy. For instance, the currency's spot price closed at 6.2597 per dollar on February 2, a low not seen in some two years, after China's official January purchasing managers' index for the manufacturing sector contracted for the first time since September 2012.

From a foreign exchange market perspective, the yuan's recent movement is nothing but a normal and reasonable correction to its unilateral appreciation for almost a decade. The year 2014 marked the first year that the yuan weakened against the dollar since exchange rate reforms in 2005.

Nonetheless, it should be pointed out that the central bank looms large behind the recent weakness in the currency. So far this year, the central parity rate of the yuan generally maintained a downward trend, with the rate hitting a two month low of 6.1385 on February 2. With the central bank behind the scenes to guide the yuan's movements, the weakening yuan clearly points to the central authorities' intention to reverse market expectations of the currency being a one-way bet.

If China wants to push forward with its market-oriented exchange rate reforms, two-way fluctuations in the yuan would be inevitable. According to the classic macroeconomic policy "trilemma," a central bank can only pursue two of the three major policy goals - a fixed exchange rate, free capital movement and an independent monetary policy - at the same time. As for China, independent policy and free capital flows are the goals of the country's financial reforms, which means it has to give up its stable exchange rate. In this sense, the renminbi will see increasing volatility in the exchange market once conditions require.

In addition, a market-driven, two-way fluctuation would also be in the interest of the central authorities' push for yuan internationalization. The International Monetary Fund (IMF) rejected in 2011 a proposition to give the renminbi Special Drawing Rights (SDR), which would add it to a basket of currencies - including the yen, dollar, pound and euro - considered to be fully international currencies. The yuan was reportedly rejected because it does not meet the criteria of being freely convertible. Yet, with the renminbi becoming the fifth most popular currency for settling global payments, recent reports indicate that the IMF seems willing to be flexible and will discuss the possibility of conferring SDR status in a review later this year. While the yuan is not freely convertible yet, the PBC's toleration for more volatility and two-way fluctuation still shows its efforts in the direction of exchange rate reforms.