A cargo ship berths at a wharf of Huanghua Port in Hebei Province

The year started off with a nervous shudder amidst steep market tumbles and the depreciation of the yuan against the U.S. dollar, raising doubts of the stability of China’s financial market. But rest assured, the effective exchange rate of the yuan remains stable, and there are a multitude of factors buttressing the Chinese currency in the medium and long term.

This is evident from the yuan exchange rate composite index released by the China Foreign Exchange Trade System (CFETS) on January 4. As of December 31, 2015, the CFETS yuan exchange rate index gained 0.94 percent from the end of 2014. Against the Bank for International Settlements’ currency basket, the yuan exchange rate gained 1.71 percent. Against the IMF’s Special Drawing Rights basket, it weakened by 1.16 percent.

The mixed movements of the three indexes mirrored the overall stability of the yuan exchange rate against a basket of currencies in 2015, as an article on the website of the People’s Bank of China (PBC) pointed out.

“Though the yuan faces depreciating pressures this year, a steep decline of [its] exchange rate against the U.S. dollar seems unlikely," He Liping, Dean of the Department of Finance at Beijing Normal University, said.

He thinks China is capable of pulling up the yuan through market intervention since its central bank still has more than $3 trillion of foreign exchange reserves available, despite the reserve’s record monthly decline of $107.9 billion in December 2015. Independent economist Ma Guangyuan argues that the shrinkage is also a result of the central bank’s intervention to stabilize the yuan exchange rate by unloading foreign reserves.

On the other hand, He said, China’s trade and current account balances still enjoy a huge surplus, which will bolster the yuan. He predicted the currency may depreciate by around 5 percent this year.

On the whole, China’s current condition is favorable enough to maintain a relatively stable yuan exchange rate against a basket of currencies, according to the PBC article. The overall performance of the economy is basically stable, the growth rate is within a medium to high range, and the economic structure is improving as reforms take hold.

Despite a slowdown in export growth, China’s share of global market exports actually expanded last year. In 2015, China registered a trade surplus of $594.5 billion. It doesn’t need to boost its exports through competitive devaluations of the yuan, the PBC article added.

Therefore, there is no basis for the yuan to continue depreciating, according to the PBC. The bank attributed its confidence to the continual growth of China’s inward and outward direct investments, significant amount of foreign exchange reserves, stability of its financial system, and increasing overseas demand for yuan-denominated assets. This year, the yuan exchange rate will continue to float in a two-way and flexible manner based on market demand and supply, with reference to a basket of currencies, the article added.

Root causes

Lian Ping, Chief Economist at the Bank of Communications, held that the exchange rate of a country’s currency is primarily determined by the country’s long-term economic fundamentals. "Though the strong dollar is spurring a reflux of capital and imposing a downward pressure on the yuan, China’s economic fundamentals and policy adjustment capability will shield the yuan from the dangers of a drastic slump," Lian said.

There are various reasons behind the current yuan devaluation, explained He, attributing it to the interest rate hike by the U.S. Federal Reserve (Fed) and bursting financial bubbles in China’s domestic market.

“Since the Fed raised the interest rate last December, some domestic and overseas investors believed that dollar-denominated assets would witness a rise in return rates, leading to the relative weakening of other currencies," He said. Part of the larger picture is that the U.S. economy is on the road to recovery with the dollar gaining strength, while conversely, China’s economic growth is braking after having reached high speeds.

Additionally, since domestic assets became overpriced in the past three to five years, bubbles began forming in China’s financial markets. Those bubbles have not been completely squeezed out, He noted. The foreign exchange market has also been affected by the pressure. There were expectations of the yuan’s depreciation at the foreign exchange market since the beginning of last year, He said.

Short-term speculation also had a hand in the recent debacle. Some speculators attempted to make a fortune from hot money trading based on yuan wagers. Although such activities don’t reflect the true market supply and demand, they still sent the wrong price signals to the market, according to the PBC article.

In fact, as early as December, a yuan short-selling trend had emerged. Complicated by the repeated downward adjustments of the yuan’s central parity in January, expectations of its devaluation became increasingly overwhelming. That encouraged unhealthy speculation throughout the global market, according to Xiao Lei, a research fellow from G-banker, an Internet financing platform focused on gold investment.

Ensuring stability

The recent depreciation of the yuan - in contrast to a more stable CFETS yuan exchange rate index - has raised the issue of the yuan’s exchange rate formation.

Ma Jun, Chief Economist of the PBC’s research bureau, told the Chinese media that the yuan’s exchange rate has already been unpegged from the U.S. dollar, though it’s not floating freely.

“The yuan’s exchange rate will be determined with more reference to a basket of currencies - that is to say, [its] value will basically be kept stable against the whole basket," Ma said. "That’s the tone set for the yuan’s exchange rate formation mechanism for the foreseeable future."

This mechanism could improve the stability of the yuan against the currency basket, while two-way fluctuations against the dollar would be widened. "Changes to the yuan’s exchange rate against the dollar would not be unidirectional," Ma stressed.

A transparent, credible, basket-based exchange rate formation mechanism can help stabilize market expectations, so that the central bank can reduce the frequency and scale of its interventions in the foreign exchange market, he said.

Ma believes the depreciating pressure on the yuan will be eased and its short selling decline when investors fully understand the mechanism. By then, positive factors such as trade surplus and the yuan’s higher interest rates compared to foreign currencies could play a greater role in the formation of the yuan’s exchange rate.

Giving more consideration to a basket of currencies will not hurt China’s autonomy in making monetary policies. Nor will the yuan’s rate be strictly pegged to the basket, he added.