Should China float the Yuan?

China’s decision to double the trading band of its currency has revived talk of it becoming a potential alternative to the U.S. dollar as reserve currency. However, the move will have little meaning for investors in the near term.

“The move is positive because it signals that China will continue to liberalize and eventually open up the capital account,” said Chuk Wong, co-manager of the Dynamic Emerging Markets Class. “But in the near-term the move shouldn’t affect investors very much.”

When a country wants to have an open capital account, they have to liberalize their foreign currency regimen, he added. China did the same by allowing the yuan to rise and fall 1%, instead of 0.5% previously, each trading day, a move that brings “the yuan closer to its fair value.”

“Longer-term investors should look at the Chinese market more positively,” said Wong. “If you invest in Hong Kong-listed Chinese companies, you’re indirectly benefiting from stronger yuan. My sense is the pace of appreciation of the Chinese currency will slow, meaning the returns coming from foreign currency gain will be smaller.”

The move comes on the back of last week’s announcement by the Chinese government that it is going to set up a cross-border payment system to settle investment and trade which will facilitate greater use of the yuan in international trade and investment.

“Overall, China wants to continue to develop and to promote the use of yuan as a settling currency in trade and investments,” said Wong. “That would be, longer-term, moving to the reserve currency status. I’m not saying that the yuan will be the only reserve currency but it could be one of the many.”

A stronger currency allows for a lower trade surplus, a consequence China has been able to achieve by allowing the yuan to appreciate which drove down its trade surplus from 10% of its GDP five years ago to about 2% last year.

However, the loosening of the yuan has little impact on China’s efforts towards a soft landing, said Wong.

“I don’t see it is a part of the package to manage slowdown [but] part of the long-term process to liberalize or to regulate the foreign currency regime,” he said. “What I do see, though, that when you have a more flexible foreign currency regime you will increase the volatility of your currency. The high volatility of currency should discourage some of the speculative fund flows.”

Until recently, yuan was considered a one-sided bet against the dollar. “Everybody expected it to appreciate against the U.S. dollar and, therefore, it’s been attracting a lot of hot fund flows into the country,” Wong says.

However, that is an undesirable consequence from the standpoint of the policymakers.

“Now with the wider band and medium-term high volatility of currency tends to discourage speculative fund flows,” said Wong. “So the decision is more a part of the structural change on the currency front than being used as a tool to manage the economic slowdown.”