(Yicai Global) Dec. 30 –The China Foreign Exchange Trading System (CFETS) will be inaugurated in 2017, said the Foreign Exchange Trading Center of the Chinese State Administration of Foreign Exchange (SAFE). The number of currencies in the CFETS yuan exchange rate index basket will increase from 13 to 24 as the weight assigned to the US dollar drops from 0.264 to 0.224.
Given the ongoing devaluation of the yuan against the dollar, the market has perceived the dollar's weight reduction as a signal that the People's Bank of China is trying to stable the yuan's exchange rates. However, several industry experts told Yicai Global that the cut will not have any substantial impact on the yuan's central parity rate. CFETS is only one of three baskets affecting the yuan's forex rates so cutting the dollar's weight in CEFTS alone will not 'pump up' the yuan, instead it will further liberalize the exchange rate formation mechanism, the experts added.
China has gradually improved the yuan's exchange rate formation and delivery mechanism since its inclusion in the SDR basket.
Following the latest CFETS adjustments, 11 new currencies will be added to the yuan exchange rate index basket, these are the South African rand, South Korean won, United Arab Emirates dirham, Saudi riyal, Hungarian forint, Polish zloty, Danish krone, Swedish krona, Norwegian krone, Turkish lira and Mexican peso.
After the reform, the CFETS basket will react less quickly to the dollar, Zhao Qingming, deputy director and chief economist of China Financial Futures Exchange, told Yicai Global. Overall, the USD index rose 2 percent in late 2016, causing the CFETS CNY index to fall 1 percent. After the adjustments, a 3 percent gain in the USD index will translate into a 2 percent devaluation of the yuan against the dollar.
In addition to CFETS, added Zhao, the yuan is also linked to the Bank for International Settlements (BIS) currency basket. The existing BIS currencies referenced for gauging the CNY exchange index and their weights will remain unchanged in 2017, according to the Foreign Exchange Trading Center.
The Chinese central bank adopts a flexible and effectively-managed foreign exchange system, so the adjusted weighting of the dollar in the CFETS basket will have a negligible impact on the yuan's exchange rates overall, said Zhao.
The renminbi formation mechanism will be further liberalized
The rationale behind the dollar's weighting adjustment is specified in a document issued by the Chinese Foreign Exchange Trading Center. The total weight assigned to the currencies newly added to the basket is 21.09 percent, and the basket now covers currencies of China's biggest trade partners.
Trade weighting is the primary consideration for the reform, and the goal is to match CFETS currencies with the weightings given to the corresponding countries in trade activities, said foreign exchange analyst Han Huishi.
Similarly, lowering the dollar's weight has significant implications for the reform of the CNY exchange rate formation mechanism. If the yuan is only pegged to the dollar, the resulting exchange rates do not reflect the yuan's actual value in foreign trade activities, said Wen Bin, chief analyst at Minsheng Bank. As China scales up trade and investment in Southeast Asia and Europe, changes in the real economy should also be accurately reflected by price fluctuations associated with the exchange rate formation mechanism.