Where now for the yuan? Only the PBoC really knows

Chinese authorities have promoted the use of the yuan worldwide, while the U.S. dollar dominates global transactions.
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Even as China's central bank weakened its yuan fixing further on Wednesday, uncertainty remains about Beijing's commitment to a floating currency.

The People's Bank of China (PBoC) set the yuan fixing at 6.3306 against the U.S. dollar on Wednesday, 1.6 percent weaker than the previous day's level, signaling its commitment to the change it set out in Tuesday's press release: daily fixings would now be determined by the previous day's closing spot prices and market-moves of other major currencies.

The currency tumbled 1.6 percent on Wednesday following Tuesday's 1.8 percent plunge. The PBoC has said it was aiming for a devaluation of around 2 percent.

Despite the weaker fixing, the central bank said on Wednesday that there was no basis for continued yuan depreciation, citing "ample forex reserves" and a "stable financial system" as supportive factors of exchange rate stability.

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But analysts said it could be weeks before it was clear what China intended for the yuan.

"It all depends on whether this step-change is the start of a move towards a more flexible exchange rate regime or an old-style devaluation. As the weeks unfold it will become clear whether Beijing is indeed minded on allowing more flexibility," Diana Choyleva, head of research and chief economist at Lombard Street Research in a report.

"While Tuesday's language seems to hint at a major step in the reform of the FX regime, we caution to read too much into this statement," JPMorgan (JPM) economists echoed in a note. "In the weeks or even months to come, what would happen if spot continues to trade on the weak side of the band?"

If the yuan's fixing will be more market-oriented as the PBoC intends, that implies greater volatility and weakness ahead.

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But therein lies the PBoC's dilemma; substantial currency devaluation doesn't bode well for overall confidence amid a volatile stock market, as well as Beijing's desire for inclusion into the International Monetary Fund's Special Drawing Rights (SDR) basket, Goldman Sachs noted in a Wednesday report.

"While more FX flexibility is likely helpful [for SDR inclusion], a sharp, government-engineered currency weakness against the dollar will likely create unnecessary political resistance to the process," Goldman said.

An IMF spokesperson confirmed on Wednesday that Tuesday's historic move was "a welcome step," but one that had "no direct implications for the criteria used in determining in the composition of the SDR basket."

Moreover, a weaker yuan also heightens the risk of capital outflows. The PBoC has consistently intervened to keep the yuan stable, resulting in foreign-exchange reserves sliding to a two-year low at the end of July.

"If you toy with the currency too aggressively, you risk a more aggressive capital flight coming out of domestic assets like the property market or A-share equities. Neither of those is palatable for policymakers," Michael Kurtz, global head of equity strategy at Nomura, told CNBC.

Several experts believe the PBoC will continue stabilizing the currency.

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"Our base case remains that Beijing will continue to resist the devaluation temptation because it would not significantly help Chinese exports and economic growth, could lead to destabilizing capital outflows due to expectations of further devaluation and exacerbate the financial burden of Chinese companies with large and unhedged foreign currency debt," BNP Paribas explained in a note on Wednesday.

"While further depreciation is likely over the next 12 months, the PBoC is unlikely to see it regarded as a one-way trade," echoed Angus Nicholson, IG market analyst.

Given the lack of clarity on the PBoC's intentions, banks including Goldman have outlined various scenarios detailing the magnitude and speed at which depreciation may take place.

Scenarios include a one-off reset for now and moderate depreciation leading up to and post the SDR decision, a 3-5 percent weakening in three months, and an abrupt 10 percent devaluation. Goldman is betting on the second option, pointing to comparable episodes in January and November last year as historical reference points.

Devaluation over the course of a protracted period is widely expected to generate a much more panicky market reaction than a one-off move, JPM economists said.