The recent decision of China’s central bank, the People’s Bank of China (PBOC), to make improvements on its "central parity system" to better reflect market movements in the exchange rate between the Chinese yuan or renminbi (RMB) against the U.S. dollar has caused the value of the RMB to fall sharply.
The PBOC made the policy change effective on Tuesday, Aug.11, which required that daily central parity quotes reported to the China Foreign Exchange Trade System before the market opens to be based on the closing rate of the inter-bank foreign exchange rate market on the previous day, supply and demand in the market, and price movement of major currencies.
The central bank said that the policy change was based on key considerations, such as the strong U.S. dollar and the sharp appreciation in the yuan exchange rate. It said that the authority and the "benchmark status" of the central parity system was "undermined" when the renminbi's central parity deviated from its actual market rate "by a large extent and for a long duration."
According to the report, the central parity rate of the yuan weakened following the change, from 6.2298 against the U.S. dollar compared to 6.1162 on Monday Aug. 10, down nearly 2 percent, a record low since April 2013.
The PBOC, however, described the sharp lower rate as a "one-off" adjustment, which linked the previously accumulated differences between the central parity rate and the market rate, as it vowed to closely monitor market movements in the future to stabilize market expectations and ensure that the new exchange rate formation system would become effective.
The PBOC also pledged to exert more efforts to promote foreign exchange reform and make it more "market-oriented," as well as further open up foreign exchange market to include qualified foreign entities and unite onshore-offshore renminbi exchange rate.
According to analysts, the central bank's policy gives market forces more power in determining the exchange rate and would send the renminbi into the benchmark currency basket of the International Monetary Fund (IMF).
"Today's move is likely intended to improve the 'market-driven' quality of the PBOC daily fix, so that it can qualify to be used by the IMF as a Special Drawing Rights (SDR) reference rate," Wang Tao, chief China Economist at UBS, said. Wang is expecting the USD-CNY exchange rate to be around 6.5 by the end of 2015, higher than his previous forecast of 6.3.
In July 2005, China officially started foreign exchange reform when the central bank decided to detach the yuan from the U.S. dollar and allowed it to fluctuate against a basket of currencies. The yuan then rose or fell by 0.3 percent from the central parity rate each trading day on China's spot foreign exchange market. But since March last year, the trading band expanded to 2 percent, with the market expecting it to expand to 3 percent in the future.