SHANGHAI/BEIJING - China's central bank rattled speculators this week by engineering a sudden fall in the yuan against the dollar, but economists warn that induced downside risk was no substitute for true liberalisation in the currency market.
Unless the central bank takes bolder steps toward allowing the market to determine the exchange rate, traders believe the correction could do little more than present speculators with a fresh buying opportunity.
Beijing has committed to letting the market determine the yuan's true value, part of a wider project to encourage international usage of the currency to rival the dollar.
The yuan's orchestrated reversal also has unleashed speculation that the central bank is preparing to widen the currency's daily trading band, currently set at 1 percent either side of a daily midpoint fixed by central bank.
But even if the band is widened, traders doubt whether it can hold the yuan back from strengthening further, given the enduring ability of Chinese assets to attract capital inflows.
Since Jan. 13, the spot yuan has undergone an unprecedented fall of more than 1.5 percent, guided downward by the central bank with the help of major state-owned banks, which traders say were selling off yuan at the central bank's behest.
Wang Jun, senior economist at the China Centre for International Economic Exchanges (CCIEE), a well-connected think-tank in Beijing, told Reuters that the central bank had to deliver a clear message to speculators.
"It needs to tell the market, 'No more one-way rise for the yuan,' and introduce two-way fluctuations in the rate like other major currencies have," Wang said.
The country's foreign exchange regulator attempted to soothe markets on Wednesday afternoon, saying that the adjustment was "normal," resulting from market players independently unwinding their long yuan positions. But most participants believe this unwinding was defensive, triggered by state-owned banks' massive dollar purchases.
As a relatively low-risk, high-yield currency that has gained over 35 percent against the dollar since it was revaluated in 2005, the yuan remains a favorite among international investors.
The Greek debt crisis in early 2012 did provoke a brief swoon that saw the currency lose 1.6 percent in six months, but it began to recover in July 2012 to gain as much as 5.5 percent by mid-January.
In reaction to this inexorable rally, speculators onshore and off built huge long yuan positions on assumption that the bull party would run and run.
Speculative foreign capital inflows appeared to gather pace from the fourth quarter through January, data from the State Administration for Foreign Exchange suggested. Most economists expect the trend to continue this year, unless the yuan enters an extended decline.
The PBOC has attempted to deter yuan bulls in the past, but seldom achieved much success.
Most economists and traders still expect the yuan to appreciate between 2-3 percent this year, even given recent developments.
There is little economic justification for letting the yuan slide. Economists say depreciation would do little to help exporters, for whom the yuan's strength is a minor irritant compared with the explosive rise in labor, material, and rental costs.
GaveKal/Dragonomics research house economists Chen Long and Arthur Kroeber argued in a report titled "No, the Renminbi Is Not Tanking" that the PBOC's short-term goal is to mislead speculators into thinking the era of yuan appreciation is over, panicking them into liquidating long positions at a loss.
"Some observers have leapt to the conclusion that Beijing is spooked by slower economic growth and the recent sharp devaluations by emerging-market competitors, and now wants to drive the currency lower to keep its exports competitive," they wrote. "We don't buy it."
TIMING THE MARKET
While most agree that widening the band would be a positive incremental step toward further reform, by itself it cannot introduce genuine downside risk so long as the PBOC and its allies at the major state-owned banks continue to meddle.
Indeed, when the PBOC widened the yuan's trading band from 0.5 percent to 1 percent in April 2012 the market confounded expectations by becoming less, rather than more, volatile.
That's because the central bank continued to use the daily midpoint to restrain appreciation, setting it so that the spot rate remained on a tight leash.
In reaction, traders refused to do business anywhere near the midpoint and simply waited for the PBOC to cave in and let the yuan rise again - a bet that has consistently paid off until recently.
"What the PBOC wants to do is inject more volatility in the FX market; band widening seems to be the emerging consensus view on the simplest way to doing that," said the head of FX trading at a European Bank in Hong Kong.
"But that is hardly going to be enough if the market believes the CNY is going to appreciate in the long term," he added. "What is needed is a more market-determined exchange rate."