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China's basket case: Renewed depreciation or reform?

Currency exchange yuan dollars
Tyrone Siu | Reuters

Beijing wants you to know that the yuan—already at four-and-a-half-year lows against the dollar—may fall further. Just that you shouldn't worry too much about it.

Late on Friday, the China Foreign Exchange Trade System (CFETS), a sub-institutional organization of the People's Bank of China (PBOC), introduced a new exchange rate index that will see the yuan (CNY), or renminbi, valued against a basket of 13 trade-weighted currencies

It isn't clear if the PBOC will ever formally tie the yuan to this gauge but CFETS did say the basket includes both G3 and Asian currencies, such as the Singapore dollar, Thai baht and Hong Kong dollar. Noticeably, it excludes the Korean won, Indian rupee and Taiwan dollar.

A slowdown in China's once-booming economy, growing expectations of tighter monetary policy in the U.S., and capital outflows have all hurt the renminbi recently. The central bank surprised markets in August by devaluing the yuan but that hasn't stopped investors from placing bets on further turmoil. Recent lower fixings against the greenback have also supported that view, with the PBOC setting Monday's midpoint rate at 6.4495 per dollar, the weakest level since 2011.

"The timing of the announcement is probably not a coincidence, just prior to expected Fed tightening that could push the dollar stronger. The PBOC is clearly preparing the market to interpret a weaker yuan against the dollar as not being devaluation, but rather consistent with stated policy goals, in an effort to limit the possibility of triggering financial market instability," said Societe Generale analysts in a Monday note.

This argues that the PBOC undertaking further gradual and controlled renminbi depreciation, they added.

Given the inclement backdrop, the PBOC's latest step may be aimed at drawing attention to the yuan's steadier performance against a wider set of currencies, in contrast with the more volatile moves against the dollar. The PBOC's hope is it can guide the yuan lower without sparking market unease.

"Shifting the market's yuan focus to a basket of currencies is an attempt to manage market expectations away from yuan weakness against the dollar," Bank of America Merrill Lynch explained in a Monday note.

"By referencing a basket of currencies, we believe the PBOC is leaving more room for further CNY depreciation against the dollar in the future. This would be particularly important if the Fed rate hike and the expectation of further hikes trigger significant dollar strengthening against developed market and EM currencies."

Friday's announcement makes it easier for the authorities to offset anticipated dollar strength without causing a major increase in policy uncertainty or expectations of a sharp one-off devaluation ahead, Goldman Sachs chimed in a separate note.

Still, economists agree that the new index signals the beginning of a more transparent managed float regime.

The new index brings the mainland one step closer to a "clean floating" foreign-exchange regime, according to a recent report by HSBC, as the world's second-largest economy looks to challenge America's dominance in the world of international finance. Beijing has already made strong strides in that regard, as seen by the International Monetary Fund's decision to include the yuan into its basket of global reserve currencies.

CFETS itself said on Friday that the index offers "a more comprehensive and accurate way to assess market conditions."

However, it remains to be seen whether the index, similar to what Singapore uses, will actually materialize.

"It is important to note that this is a CFETS index and not published by the central bank... It is not immediately clear as to whether PBOC or other Chinese officials will strictly refer only to the new CFETS measure going forward," HSBC warned.

Moreover, even if the PBOC formally approve the index, there is a chance the renminbi could actually strengthen after a period of initial weakness.

"There will be a frontloading of dollar strength and then the dollar will begin to weaken by the second half [of 2016] so we may find the renminbi may be stronger by end-2016 that it is today," explained Adrian Mowat, JPMorgan's chief Asian and emerging market equity strategist.

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