Investors could be forgiven for being skeptical about China's announcement over the weekend that it will link the exchange rate of the yuan to a basket of currencies.
Back in 2005, China made a similar announcement, only to allow the yuan to steadily appreciate against the dollar with no apparent reference to a basket.
This time around, however, there are signs that the People's Bank of China may be serious, and could even model its new policy after Singapore, which links its currency to a secret basket of global currencies.
If in fact China starts benchmarking the yuan to a basket, knowing what's in the basket and how it operates will be key to forecasting the value of the currency, a vital question for investors, traders, and businesses around the world.
A currency basket would mean that the yuan could fall as well as rise against the dollar, thus making life harder for speculators. If other currencies in the basket such as the euro or the yen are falling against the dollar, the yuan might fall as well, which could enrage those in the U.S. calling for it to rise.
China could still aim for an overall appreciation if that is what they want. Internally, Beijing would set a target for appreciation or depreciation against the basket as part of its overall macroeconomic policy, as Singapore has long done.
Following China's announcement in July of 2005 that it was ending its 11-year peg to the dollar, analysts found that the yuan was making a steady, almost uninterrupted climb against the dollar. China may have been 'referencing' a basket of currencies, but it didn't seem to be acting on it.
The perceptions that the yuan was on a one-way track upward created unanticipated consequences. Speculative capital flowed into China from abroad, seeking to profit from the predictable appreciation. Those inflows were destabilizing, contributing to inflation and asset bubbles, and compromising the effectiveness of Beijing's macroeconomic tightening.
Aware of those costs, Beijing appeared to change course during a brief period starting in April of 2008, said Bank of America Merrill Lynch economist Lu Ting, and the yuan seemed to begin tracking a trade-weighted basket of currencies. But that experiment was cut short by the financial crisis, and from July onward Beijing essentially froze the yuan against the dollar.
This time around, officials seem at pains to convey that the currency may move down as well as up. In its statements over the weekend, PBOC was careful to stress that the yuan will be flexible 'in both directions.' It also stated repeatedly that the currency should not be tied to the dollar alone.
'It's not appropriate given China's diversification of trade and investment that the yuan is fixed solely to one currency as it won't accurately reflect the real value of the yuan. Multi-currency baskets better reflect the real value of a currency,' the central bank said. 'As far as firms and individuals are concerned, given the diversification of trade and capital, we should not purely measure the yuan against the dollar, but instead assess the yuan against changes in a basket of currencies.'
Such explicit statements lead many analysts to believe that China has shifted its thinking and will now base its daily fixing of the currency on a wider group of currencies. But others are not convinced. Mark Williams, an economist at research group Capital Economics, says allowing the yuan to fall against the dollar in the current political environment would be 'extremely provocative.'
'If they do adopt a basket, I believe it's likely to be a basket composed almost entirely of dollars,' he said. 'It's clear that big decisions on Chinese currency policy are as much political as economic.'
All eyes are now on the yuan's movements, and in particular the central parity rate set daily by the PBOC, around which the yuan is allowed to trade in a narrow band. It's difficult to draw conclusions from the yuan's up-and-down trading in the past few days, but in the weeks and months ahead, traders and investors will be tracking the currency and testing it against their models to determine if it is based on a basket, and if so, what exactly is in that basket.
China has in the past given hints as to the composition of the basket. In 2007, PBOC Governor Zhou Xiaochuan said at a press conference that there are 20 currencies in the basket. In 2005, he said the basket is weighted mostly to the U.S. dollar, the euro, the Japanese yen and the Korean won. The currencies of Singapore, the U.K., Malaysia, Russia, Australia, Canada and Thailand are also included, he said.
At the time, market participants weren't very focused on the basket's composition, since it was clear that it wasn't determining the yuan's value. This time, if China is indeed setting the yuan against the basket, forecasters, traders, banks and exporters will all be keen to determine its exact composition.
Secrecy is key. If the composition of the basket were known to the market, speculators would know where the yuan is headed based on the movements of other currencies. Beijing wants to eliminate the possibility of a 'one-way bet' such as that which existed under its previous crawling peg to the U.S. dollar. Singapore's basket is weighted according to its level of trade with other nations, but its exact composition is not disclosed.
'If we have a policy to say the yuan will appreciate against a basket, can you really speculate on that? Yes, you can. But it's much more difficult than if you say it will appreciate against the dollar,' said Lu.
Of course, market participants will come up with estimates of the basket's composition to guide their trading, as Bank of America Merrill Lynch does, but there's no certainty. Beijing could change the basket at any time without telling anyone. Since its currency policy is not explicit, China could also depart from basing the value on a basket whenever it chooses. 'The model is not necessarily right. We've got our model, but other banks have their own very different models,' said Lu.
Lu constructed a model of the basket based on China's level of trade with other nations, as well as the composition of its foreign debt holdings and foreign direct investment. He estimates that the U.S. dollar has a 40.3% weight in the basket, making it the still the largest determinant of the yuan's value. Next comes the euro at 16.0%, and the yen at 12.6%. Illustrating the guesswork that goes into the process, Lu also figures that India, Brazil, Indonesia and the Philippines have grown in importance to China's trade since Zhou listed important currencies in 2005, so he added them to the model.
Lu said it will take around two months of observing the yuan's movement before anyone can draw a conclusion as to whether the yuan is indeed tracking such a basket.
Had China been strictly tying the yuan to a basket in recent months, it would have probably followed the euro down, thus falling against the dollar. Royal Bank of Scotland economist Ben Simpfendorfer said a yuan that falls significantly against the dollar is 'unthinkable' in the near term. Such political considerations mean that China is unlikely to adopt a strict basket-based system in the near term, he said. 'Ultimately they may be headed in that direction, but I think we're years away.'
这样明确的声明使许多分析师认为，中国已改变了想法，将把人民币每日定盘价与更多货币联系起来。但有人却不相信，研究公司Capital Economics经济学家威廉姆斯（Mark Williams）说，如果在当前政治环境下允许人民币兑美元走软，将“极具挑畔性”。
如果近几个月中国一直严格把人民币与一篮子货币联系，那么随着欧元下跌，人民币兑美元可能已经走软了。苏格兰皇家银行（Royal Bank of Scotland）经济学家贝哲民（Ben Simpfendorfer）说，短期内人民币兑美元大幅下跌是“不可能的”，这样的政治考虑意味着短期内中国不太可能采用严格的一篮子货币体系。他说，最终他们可能向那个方向发展，但我认为还需要几年时间。