Three issues were thrown open for debate as a result of the August exchange rate reform, which has changed people's expectations

At the beginning of 2015, no one would have expected the renminbi's exchange rate to become key to China's macroeconomics. Before August, the renminbi's exchange rate changed gradually, appreciating by about 2 percent every year, and its volatility was around 2.5 percent.

But the exchange rate reform on Aug 11 has totally changed people's expectations. China's central bank obviously doesn't want the market to follow the point position or the depreciation rate - it wants the market to follow a fluctuation range.

After Aug 11, the central bank and speculators engaged in many rounds of battle in the foreign exchange markets. We could see their divergence on exchange rate issues, and then make our judgments. As a result, several issues have been up for debate.

First issue: Is China's trade surplus sustainable?

From January to November, China's exports saw a year-on-year decline of 3 percent, while imports saw a year-on-year decline of 15.1 percent. Since July, every month's data has been worse than predicted, so there are many voices in the market saying that the renminbi should depreciate, so as to boost exports.

We have done research that shows the exchange rate elasticity of China's trade exports is gradually falling.

After exchange rate reform, China's trade growth sensitivity to the renminbi exchange rate has been reduced from 2 to 1.5, which is similar to calculations by the World Bank that show that the exchange rate influence on exports has been reduced. However, China's export exchange rate elasticity is still much higher than the world average of 0.6 - that is, although the influence is falling, the renminbi exchange rate depreciation could still effectively boost China's exports.

From the central bank's point of view, although foreign trade import and export data has not been good, there are still some bright spots.

One is that China's exports have been mostly steady and have seen some growth, and export companies' competitiveness has been improved. From January to September, the ratio of Chinese goods among total imports has increased in the United States, the European Union and Japan, with the US increased from 20 percent to 23 percent, and Japan from 24 percent to 28 percent. It shows that the main reason for China's export decline is the slowdown in overseas demand, not the overvaluation of China's renminbi exchange rate.

Second, the declining trade surplus has increased the US dollar supply in China. Because import growth declined faster than the export growth from January to November, China's trade surplus still reached $530 billion. This amount of dollars entered the domestic foreign exchange market, which could relieve the renminbi's depreciation pressure. It looks like the declining trade surplus could last for some time.

So although depreciation would benefit exports, the central bank doesn't plan to, or need to, use exchange rate depreciation to boost export.

Second issue: Is the central bank's intervention in the foreign exchange market sustainable?

After the Aug 11 reform, the central bank released the macro-prudential policy of forward settlement and sale exchange reserve fund, and other capital control policies including pausing the RMB qualified domestic institutional investors program. These measures are more effective than using the foreign exchange reserve to interfere, but its impact in twisting the foreign exchange market will be bigger.

The central bank isn't too concerned about reducing the foreign exchange reserves. If the decline of the foreign exchange reserve is due to domestic residents' demand to increase holdings of US dollars, it could actually reduce the government's pressure to manage the huge foreign exchange reserve.

However, if the decline is due to the central bank's intervention in the offshore market, and earned by foreign arbitrage, it is the public's loss. That is why we see the central bank tightening the volatility of the offshore market renminbi, and reducing the cost of the direct intervention in the foreign exchange market.

The central bank is just a tool to stabilize the over volatile exchange rate. However, the intervention itself will twist the market structure, so it won't be a permanent solution.

Third issue: With the International Monetary Fund having announced the inclusion of the renminbi in the special drawing rights basket, will forced reform continue?

On Nov 30, the IMF made public the renminbi's inclusion in its reserve currency basket. But there are many financial reforms that need to be promoted. The IMF has released the evaluation report on the renminbi's inclusion, which emphasized two points. One is that the renminbi's fluctuating rate is lower than that of other international currencies. Second is that there's a relatively big divergence in the renminbi's onshore and offshore exchange rates.

It is not easy to solve these two problems. After the Aug 11 reform, the onshore renminbi exchange rate's implied fluctuating rate increased from the initial 1.5 percent to 5 percent. It is still much lower than the 9 percent fluctuating rate that emerging markets and developed countries have at the same time.

The main reason is that, in China's domestic foreign exchange market, individuals' and enterprises' exchange settlement and sales are still restricted by the actual demand principle. So every day the actual exchange volume is only about $30 billion. When the central bank sets the median price, the renminbi won't have much of a large fluctuation.

This year, if the central bank takes the IMF's suggestion to continue increasing the renminbi fluctuating rate, then the central bank's tolerance for renminbi exchange rate depreciation will also increase. Since, in the past, the implied fluctuating rate was closely related to the annual appreciation rate of the renminbi, in the future the upper limit of renminbi exchange rate depreciation might exceed the upper limit of the annual appreciation.

The renminbi onshore and offshore exchange rates' divergence will continue for some time. After the Aug 11 reform, the renminbi onshore and offshore exchange rates divergence has been maintained at about 300 to 600 points, which is far beyond the normal intervals.

In a normal market situation, the price of the offshore exchange rate follows the onshore market. However, once the subjects of the onshore market cannot figure out the future trend of the market, then the offshore market's financial institutions cannot come up with accurate pricing for the future exchange rate, so the fluctuation of the CNH (offshore yuan) will be dramatically enlarged. And because the transaction volume is very big, it will in turn affect the exchange rate pricing for the CNY (onshore yuan). This is what happened after the Aug 11 reform.

From the perspective of the entire financial market reform, the central bank won't connect exchange rate reform with promotion of imports and exports. Also, it won't have concerns about the lack of capability of intervention, and it won't stick to one certain point position. The target of reform is to strengthen the elasticity of exchange rate. While new information will be reflected in exchange rate fluctuation, the central bank's intervention policies will make adjustments accordingly.

All in all, this year, the fluctuation rate of the renminbi exchange rate will be key. It is predicted that the onshore market's implied fluctuation rate will gradually be increased to about 6 percent, and for the whole year the onshore renminbi's exchange rate against the US dollar will fluctuate between 6.4 and 6.8.

The author is deputy director of the Research Center for International Finance of the Institute of World Economics and Politics Research at the Chinese Academy of Social Sciences. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 01/29/2016 page10)