China's move towards a freely-floating yuan has found a powerful ally

Photo by Adam Berry/Getty Images

While it has rattled markets and drawn the ire of some influential people, the People’s Bank of China’s decision to allow market forces to play a greater role in setting the level of the yuan has pleased at least one group – and a powerful one at that.

In a statement released earlier today, the International Monetary Fund noted that the move is a “welcome step” in its opinion.

“The new mechanism for determining the central parity of the Renminbi announced by the PBOC appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate,” said an IMF spokesperson.

“Greater exchange rate flexibility is important for China as it strives to give market-forces a decisive role in the economy and is rapidly integrating into global financial markets,” they noted, adding “we believe that China can, and should, aim to achieve an effectively floating exchange rate system within two to three years.”

On Tuesday the PBOC announced a change the to the methodology used to determine the yuan’s trading level. Instead of the bank solely determining the rate, it announced that market participants, using the previous days closing level, would now play a greater role in determining the yuan’s initial trading level

Fitting with the weaker spot USD/CNY close on Monday afternoon, the PBOC fixed the yuan rate nearly 2% weaker than Monday’s opening level.

The sudden announcement certainly blindsighted the markets, sending the US dollar screeching higher to the detriment of risk assets globally.

While deemed to be a welcome step, the move to allow market forces to play a greater role in determining the level of the yuan – as yet – has not swayed the IMF on the possible inclusion of the currency in its special drawing rights (SDR) basket.

Last week the fund hinted it may delay the decision to include the yuan in its SDR basket until September 2016. One of the criticisms leveled at the currency was a lack of market forces used to determine its trading level.

“The announced change has no direct implications for the criteria used in determining the composition of the basket. Nevertheless, a more market-determined exchange rate would facilitate SDR operations in case the Renminbi were included in the currency basket going forward,” said the spokesperson.

“The exact impact will depend on how the new mechanism is implemented in practice.”

That final point is key, particularly given the new yuan fixing methodology remains opaque to market participants.

While the PBOC has stated that broker quotes based off the previous day’s closing level will be used to determine the yuan fixing moving forward, the degree to which the bank will allow market forces to determine this remains a mystery.

Today, for instance, the PBOC fixed the yuan at 6.3306, weaker than the closing level of 6.3250 of Tuesday.

While in line with the weakness seen in offshore yuan trading yesterday – the USD/CNH fell more than its onshore equivalent, the USD/CNY – it suggests that the PBOC fixed the yuan this morning based off market forces.

However, at the moment the currency is weakening, something that is deemed to be beneficial for the economy given weakness in recent trade and inflation data.

It’s essentially helping the economy at present, rather than hindering it.

Until markets and the IMF see the yuan move in a direction that is not beneficial for the economy – something Australia and more recently the US know all about – question marks over the involvement of market forces in determining the yuan’s level will persist, as will the level of scepticism towards the PBOC’s decision.

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