China faces stiff battle to sideline the dollar in valuing yuan

Beijing officials face a long list of worries as China's yuan posts its biggest annual fall in more than two decades, and Donald Trump's threats to impose tariffs on Chinese imports could add further pressure in 2017.

BEIJING (BLOOMBERG) - China took another step to degrade the dollar in defining the value of its currency, in an effort that cuts against its rival's stubbornly strong hold on the global financial system.

An arm of the People's Bank of China, which last year started setting the yuan against a basket of currencies, on Thursday said it's adding 11 units to that reference group. The move lowers the dollar's weighting by 4 percentage points, to 22.4 percent - little more than twice the share for South Korea's won, a new entrant.

While the logic of determining the yuan's value against the currencies of its trading partners is clear, the problem is that the dollar is still the dominant reference in the perception of the public and the market. The US currency is on one side of 88 per cent of all foreign-exchange trading.

"The US dollar-yuan rate will still be the benchmark that determines sentiment," said Hao Hong, chief strategist in Hong Kong at Bank of Communications International Holdings, a subsidiary of China's No. 5 lender by market value. "The basket is just a reference, so the change in the index's composition and the efforts of keeping it stable will do little to boost confidence."

The yuan's retreat against the CFETS RMB Index, the basket set by the China Foreign Exchange Trade System, has been more moderate this year than against the US dollar, as the currencies of China's trading partners have also declined. In recent weeks it's even advanced.  That offers an image of stability that would appeal to a Communist leadership that's striving to maintain economic growth in excess of 6.5 per cent and reduce leverage, all while heading off any exodus of domestic capital.

The challenge is that China's swelling middle class, along with its ultra-wealthy, are looking to diversify some of their increasing pool of savings overseas. Prospects for higher US interest rates only increase the allure of the dollar.

Simply adding currencies such as the won, South Africa's rand, the dirham of the United Arab Emirates, Saudi Arabia's riyal, Hungary's forint, Poland's zloty and Turkey's lira won't be sufficient to change the public's view, according to a panoply of analysts from institutions including Royal Bank of Scotland Group, Bank of Communications and ICBC International Research.  The background to this week's announcement: an accelerating outflow of funds that's seen China's foreign-exchange reserves slide, the PBOC's yuan positions drop last month by the most since January.

"The yuan will continue to depreciate against the greenback and the pressure of capital outflow will likely persist in 2017," said Mr Hong, who estimates a "fair" rate would be 7.5 per US dollar, against around 6.9453 in trading Friday.

"Adding a batch of emerging-market currencies into the basket will likely increase two-way volatility of the yuan's fixing and the exchange rate," said Ken Cheung, Hong Kong-based Asia currency strategist at Mizuho Bank Ltd. "If the dollar extends its rally next year, particularly against the emerging-market currencies under Donald Trump's presidency, the onshore and offshore yuan will come under heavier pressures."

CFETS said Thursday that the weighting of the yuan's basket will be evaluated on an annual basis and updated at the "appropriate time". The US dollar and currencies that are pegged to the greenback, such as the riyal and the Hong Kong dollar, will take up 30.5 per cent of the new basket, down from 33 per cent currently. The won will make up 10.8 per cent. 

The changes start with the turn of the year. Also kicking in at that time: the renewal of citizens' US$50,000 (S$72,524.5) quota of foreign-currency purchases. The likelihood of further Federal Reserve rate hikes, and concern that US President-elect Donald Trump will slap punitive tariffs on China's exports to the world's largest economy, are adding to the challenges looming over policy makers.

One thing in Beijing's favour: a wide array of capital controls and a strong hold on the financial system, with state-owned banks dominant. Harrison Hu, chief greater China economist at Royal Bank of Scotland, says that "policy makers could offer window guidance to banks to reduce residents' dollar buying if there's panic next year."

Even so, "the basket will do little to anchor market sentiment, as no trader will trade the yuan against 24 currencies," said Mr Hu, who expects the currency to end 2017 at 7.2 per US dollar. "Chinese residents who want to buy foreign-exchange after the quota reset won't really get what a stable basket means."