LONDON • China is in a currency quandary: How to promote the yuan in global trade while at the same time using it to stabilise market volatility?
The People's Bank of China is holding the onshore version of the yuan at about 6.2 to the US dollar even as it pledges a bigger role for market forces.
In a single statement last week, China's State Council, or Cabinet, said both that it would allow the currency to move in a wider range and that the exchange rate should be stable.
A freely usable yuan is a key requirement of the International Monetary Fund's (IMF) special drawing rights (SDR) status that China is seeking.
Yet loosening controls while stocks are plunging risks the kind of swings that may spur capital outflows and disrupt the world's second-biggest economy.
"The Chinese government is panicking a little bit as they take the equity market sell-off as a threat to its credibility," said Mr Cliff Tan, the East Asian head of global markets research at Bank of Tokyo-Mitsubishi UFJ in Hong Kong.
"Different departments are coming up with what can be done, but they're mutually contradictory."
This tension is being borne out in markets, where the gap between the onshore yuan and the currency's value in Hong Kong widened last week to 0.29 per cent, the most since March.
Foreigners have been fairly sanguine about the US$2 trillion (S$2.7 trillion) wiped off the value of mainland Chinese shares, as they collectively hold less than 2 per cent of the market.
However, they have major holdings in H-shares, the US$3.7 trillion market in Hong Kong-listed stock of mainland companies, and "dim-sum" bonds, the US$70 billion-plus market for yuan denominated debt issued and traded offshore.
While the onshore rate has remained fixed, the offshore yuan tumbled the most it had in three months on July 24 as the State Council's statement sowed confusion among traders.
JPMorgan Chase and the Commonwealth Bank of Australia took the statement as a sign that China will relax the limit of 2 per cent moves either side of a daily fixing.
Achieving SDR status would be the crowning achievement of China's efforts to boost global use of its currency and challenge the dominance of the dollar.
The yuan failed to make the cut in 2010 because it was not deemed to be freely usable. The next five-yearly review is scheduled in November. It is critical for China to adopt a flexible, market-based exchange rate to help correct the imbalances that are limiting domestic consumption, the IMF said in a report on Tuesday.
"The intervention has been very aggressive in the foreign exchange market during this equity rout," said Mr Ken Peng, a strategist at Citigroup in Hong Kong. "That's an easy target for those who are opposed to China joining the SDR."
Widening the trading band will add unwanted uncertainty at a time when financial markets are already volatile, said Mr Koon How Heng, a Singapore-based strategist at Credit Suisse Private Bank and Wealth Management.
"There's just no strong or clear valid objective at this stage to widen the daily trading band," he said.
BLOOMBERG
