In August 2015, China's central bank implemented a major change to the foreign exchange mechanism for the yuan and devalued the currency by 2 percent against the U.S. dollar. The central bank described the move as a "one-time correction," but the unexpected devaluation unnerved global financial markets and eventually led to criticism that China's financial authorities weren't communicating well enough with global markets. Over the following year, however, the critics' tune has changed, as China's financial authorities and officials, such as People's Bank of China Governor Zhou Xiaochuan, have become more proactive about explaining reforms related to the yuan's exchange rate mechanism, helping them earn compliments from some of their sharpest former critics.
China's authorities have largely succeeded at their objective of revamping the foreign exchange mechanism to make the yuan more market-oriented and relatively stable to a basket of currencies over the past year, thanks to improved policy communication, U.S. experts have said.
On August 11, 2015, the People's Bank of China (PBOC), the country's central bank, announced a major change 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-time correction" to bridge previously accumulated differences between the central parity rate and the spot market rate, which would make the central parity rate more consistent with the needs of the market.
The central parity rate is the starting point for daily forex trading on the Chinese mainland. Under central bank's rules, the yuan is allowed to rise or fall by 2 percent from the central parity rate each trading day.
Communication breakdown
Think tank and the International Monetary Fund (IMF) experts agreed that the central bank's move was very much in the direction to increase the role of the market in determining the RMB exchange rate.
But some market participants at that time misinterpreted the change as an effort to prop up economic growth by devaluing the Chinese currency. These critics jumped to the wrong conclusion that China's economy was probably worse than stated. The yuan fell sharply in value in the days right after the reform took effect.
"I think initially when they started changing the system a year ago, they were not good at communication, and there was a lot of confusion in the market about what their intention was," David Dollar, a senior fellow with the Brookings Institution and former official of the World Bank and the U.S. Treasury Department, told the Xinhua News Agency.
However, Chinese authorities provided "pretty good and clear communication" about its exchange rate policy over the next few weeks and months, Dollar said, citing authorities' arguments that they wanted to have more market forces involved and there was no need for large depreciation of the currency.
Chinese officials have said repeatedly that China has no intention to devalue the yuan to gain an advantage in global trade.
China has successfully moved up the value chain into higher value-added products and its share of global exports continued to expand in recent years despite the significant appreciation of the yuan, according to Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics and a leading expert on China's economy.
China's current account surplus was about $300 billion last year, which was the largest in the world in absolute terms, indicating that China didn't need to devalue its currency to boost the economic growth, Lardy said.
"China has a large trade surplus, and it's a rapid growing economy, there's not really the basis for depreciation," Dollar said.
Clearing up uncertainties
But capital outflows from China increased significantly in September and December in 2015 as market participants expected that the U.S. Federal Reserve would start raising interest rates by the end of the year and the dollar would rise more rapidly against other currencies.
On December 11, 2015, China introduced a yuan exchange rate composite index to help guide market participants to shift focus from the yuan/U.S. dollar exchange rate to the effective exchange rate based on a basket of currencies.
The new index, released by China Foreign Exchange Trade System, is calculated by comparing the yuan 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.
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," the central bank said.
The PBOC also took several other steps, including selling forex reserves, implementing macro prudential regulations and strengthening checks on capital outflows, to help stabilize market expectations for the yuan's exchange rate, according to Guan Tao, a senior fellow at the China Finance 40 Forum and former official at China's central bank.
But the large decline in China's forex reserves and rumors about tightening of capital control measures seemed to further fuel market expectations of a weakening yuan at the beginning of this year. China's forex reserves shrank by $512.7 billion in 2015, the largest annual decline on record.
The Institute of International Finance, a global association representing about 500 financial intuitions, estimated that a large part of capital outflows from China last year were repayments of dollar-denominated debts by Chinese companies, in order to mitigate the impact of the dollar appreciation.
In an interview with the Chinese financial magazine Caixin in February, Zhou Xiaochuan, governor of the PBOC, chose a critical moment to clarify China's exchange rate policy, as Chinese financial markets prepared to reopen following the week-long Lunar New Year holidays. Zhou reiterated that China will "rely further on the market to decide the level of the currency and to achieve a more flexible foreign exchange rate."
He signaled that China will keep the yuan broadly stable versus a basket of currencies while allowing greater volatility against the dollar.
Zhou dismissed speculation that China plans to tighten capital controls and said there's no need to worry about a short-term decline in forex reserves.
He reassured investors that there is no basis for the continued depreciation of the yuan and that China would not let market sentiment be dominated by speculative forces.
Zhou's comments helped ease the yuan's depreciation pressures and received praise from the IMF Chief Christine Lagarde. "We have been delighted to see the communication efforts undertaken by policymakers, particularly Governor Zhou," Lagarde said in February, adding that it was "a good example of how communication can actually clear the uncertainties and trepidations."
