MNI INTERVIEW: Yuan To Test Peaks On PBOC Approach: Advisor

The yuan may test its five-year peaks against the dollar in 2021 as authorities adopt a hands-off approach to management of a currency used increasingly for international settlement and for foreign reserves, a former chief economist at a major state-owned Chinese bank told MNI.

The yuan is likely to strengthen to its 2015-17 high of about 6.2 to the greenback, helped by a robust economic recovery and the interest rate spread between Chinese government bonds and U.S. Treasuries, Cao Yuanzheng, chairman of BOCI Research Company and former Bank of China chief economist, said in an interview. The yuan was around 6.58 to the U.S. dollar in Beijing trade Friday.

The People's Bank of China is tolerating wider fluctuations around the daily fixing in yuan trading as the currency gradually takes on the role of a regional anchor, although authorities have made it clear they will step in to counter excessive sustained moves in the exchange rate. In recent weeks, the PBOC has suspended the use of the counter-cyclical factor in the daily exchange rate fixing formula and cut risk reserve ratios for currency forwards to zero.

"No one knows the yuan's equilibrium level…our efforts are trial and error, which is a bargaining game between regulators and investors; the precondition is no overshoot of the currency," said Cao, who was instrumental in formulating policies to internationalise the yuan from 1998 and has frequently called for capital account convertibility. He has worked for BOC for more than two decades since leaving the State Commission for Restructuring the Economic System under the State Council.

DEMAND

As the yuan has strengthened and trading volumes risen, previously-stalled efforts to promote its internationalisation have regained momentum. While the currency is far from challenging dollar dominance, the greenback's pre-eminence is being slowly eroded as the U.S. share of global GDP declines and the Federal Reserve performs large-scale quantitative easing, Cao noted.

Asian demand for the yuan should get a further boost from the recently-concluded Regional Comprehensive Economic Partnership, he said, adding that the world's largest trade deal should also allow for an expansion of the Chiang Mai Initiative, a regional currency swap agreement including ASEAN, Japan, and South Korea which was launched in 2010.

More pricing of products in yuan in Asian securities markets should also further the internationalisation of the currency, Cao said. Yet challenges remain before this goal can be achieved. The currency must become fully convertible, and deep and broad domestic financial markets are needed in order to cushion the impact of growing capital flows on the exchange rate. This will be tough in a country where bank loans are the major funding channel, so further opening up the capital account will need to be a cautious and gradual process.

HUBS

Large capital inflows are inevitable, as the PBOC's policy stance will diverge from those of its major counterparts in the next five years. These should strengthen domestic fixed-income markets and increase the global impact of the PBOC's policies, Cao said.

He called for the central bank to maintain its focus on asset prices rather than inflation, and added that China needs a more complete government bond yield curve as it moves to a more market-oriented use of interest rates to manage monetary policy.

Yuan internationalisation must also be supported by developed financial hubs, said Cao. He expects both Shanghai and Hong Kong to play a key role, with Shanghai serving as an onshore center for the yuan, as New York does for the dollar, while HK caters to offshore investors, playing a role similar to that of London in dollar markets.