There is much confusion over China's currency policy. On August 11, the PBOC seemed to signal a desire for a somewhat weaker currency. The dollar rose by nearly 4% in a two-day move.
However, after trading broadly sideways for a few sessions, the dollar weakened. Ahead of the long holiday weekend in China, the dollar slipped to its lowest level since August 11 earlier Wednesday.
Many market participants suspect Chinese officials have botched the attempt to depreciate the yuan. They argue that officials miscalculated the extent to which it would spur capital outflows.
To evaluate the PBOC's policy, however, one needs to make some assumptions regarding its intent. If the intent was to manage a economically significant devaluation, as some observers argued, given the decline in competitiveness and exports, it does not appear to be successful. Yet Chinese officials denied this was its intent. If the goal was to allow the currency to float, then it also must judged as unsuccessful.
There is an additional possibility. Immediately after the surprise move on August 11, we argued that the movement of the currency was minor and not very important economically. Instead, we argued that the new mechanism to set the daily reference rate was the key to the PBOC's decision. It is still a black box in the sense that it is not clear how the central reference rate (fix) is ultimately determined.
Nevertheless, there has been an important development since August 11 that is captured in this Great Graphic, created on Bloomberg. The white line is the closing spot price for the dollar-yuan exchange rate in Shanghai. The yellow line is the central reference rate. What China has successfully engineered is the closing of the gap between the fix and spot.
This is an important technical achievement. This is an operational necessity if the yuan is going to be part of the SDR. In order to set the daily price of the SDR that a dollar-yuan rate requires, that rate needs to be at a tradable price. The daily fix is the obvious reference rate, but it was not a tradable price as the gap between it and spot demonstrated.
While this is a critical step, additional convergence is necessary. Recall that in the run-up to EMU, the key convergence was not in the spot rate but in the forward rates. Similarly, in China there needs to be a convergence between the implied forward rate and money-market rates. There are various forms of capital controls at China's disposal. That officials chose a 20% dollar cash reserve for forward positions (including options and some swaps) starting in mid-October may be, at least in part, a push in this direction. It will likely reduce the speculative element in the forward market.
As we have argued, the important comparison is not between the central reference rate day-to-day, but the fix relative to the previous day's close. Over time, the implied forward rate and the money market rates should also converge. This represents an improvement in the fixing mechanism and operationally represents a step closer to meeting the technical requirements of SDR membership.