Stricter financial supervision needed before exchange rate flows freely

China's exchange rate system reform's aim is to eventally establish a free exchange system without government intervention, economists have said, while it is reasonable for the country to use short-term measures to stabilize the yuan's exchange rate given its immature financial market.

The most recent measure taken by China's currency authorities was to increase the number of currencies in the yuan's reference basket from 13 to 24 from the first day of this year. The central parity rate of the yuan against the dollar is set based on the average of this basket of currencies before the opening of the inter-bank market each trading day, and traders are allowed to trade 2 percent on either side of the reference rate.

The increase in the number of currencies in the basket will reduce the dollar's weight from 26.4 percent to 22.4 percent amid market speculations over the yuan's depreciation in the coming days. The change will be able to better reflect the fluctuation between the yuan and the other currencies used by China's major trading partners, according to China Foreign Exchange Trade System.

China initiated a major exchange rate reform on Aug 11, 2015, after having adopted a de facto dollar-pegging system for years, which many said was opaque and failed to reflect the yuan's real value against the greenback.

The steps were taken following the country's pledge to promote exchange rate reform to increase the volatility of the currency while ensuring it fluctuates within a reasonable margin, according to a statement released after Central Economic Work Conference that concluded in December.

Xie Yaxuan, chief economist with China Merchants Securities, has said the country needs to strengthen financial supervision before allowing the yuan to float freely. He added, however, that a free-floating yuan will not be a reality in the short term.

The current exchange rate reform has not been fully effective, putting brakes on the country's efforts to open up the financial market, according to Guan Tao, a senior fellow at China Finance 40 Forum and a former State Administration of Foreign Exchange official.

Guan said the exchange rate system reform should be combined with other moves, say, fiscal measures that would help improve economic fundamentals and thus inject confidence in the market.

Otherwise the central bank may have to consume foreign exchange reserves to dispel market fears over the yuan's further depreciation, which might be unnecessary, according to Guan.

Recent fluctuations in the offshore market reflect discrepancies between the authorities and investors. The yuan registered a record rally of 2.5 percent in the offshore market in the first week of this year following media reports that the central bank had intervened in the market, only to fall by 1.1 percent later, the biggest decline in a year.