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What comes after a more flexible yuan?

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Between a rock and a hard place [By Jiao Haiyang/China.org.cn]

China loosened its grip on the yuan-dollar exchange rate on Saturday, widening the daily trading band to two percent from one, effective starting next Monday.

The move, a major step forward in the country's exchange rate regime reform, did not surprise analysts as the central bank had made it clear it would widen the band this year.

China's currency, the yuan, started to fall against the U.S. dollar early this year after a string of appreciations in 2013. The yuan-dollar central parity rate nosedived 111 basis points on Monday, the sharpest daily decline since July 2012.

"The recent depreciations guided by the central bank have tested the resilience in the market, and in a sense prepared investors for the band widening," said Ting Lu, an economist with Bank of America Merrill Lynch.

The central bank said in the announcement that two-way yuan fluctuation will become the norm.

"The announcement strengthens its signal that the one-way bet on a gaining yuan is over," Lu said.

In the second half of last year, a significant rise in domestic interest rates coupled with one-way growth of the yuan attracted a large inflow of hot money.

New funds outstanding for foreign exchange stood at 437.4 billion yuan in January, hitting a three-month record, and all the monitored financial institutions reported rises in such funds over the past six months.

A more volatile yuan-dollar exchange rate without an appreciation trend will deter hot money inflow and perhaps result in some unwinding of previous inflow, Lu predicted.

Zhu Haibin, J.P. Morgan's chief China economist, also said a capital outflow will help drain domestic liquidity and that possible yuan depreciation could support exports.

Chinese exporters, who may need time to adapt to a more volatile yuan, will overall benefit from the band widening, which sends a strong signal for the end of one-way appreciation, they said.

To dismiss worries over risks of large-scale money outflow, Lu noted that China has a massive four-trillion-dollar foreign exchange reserve and a 20-percent reserve requirement ratio (RRR).

If there is a money crunch in the interbank market, the central bank has a lot of room to inject liquidity, including cutting the RRR, according to Lu.

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