China's change in exchange rate mechanism raises eyebrows

Last Friday (May 26), the People's Bank of China announced that it was changing the way it fixes the dollar-yuan exchange rate at the start of the trading day. The new method combines earlier criteria with "countercyclical factor." Officials said that the move was intended to deal with overreaction of markets driven by herding behaviour. To date the fixing rate has been said to be based on bids of selected banks, which in turn are based on the closing rates of the previous trading day and the supply and demand situation in forex markets.

Even with the current criteria, it is still unclear how the daily fixing rate is actually determined. Adding a vague countercyclical factor does not clarify the situation. The reform apparently increases the flexibility of currency officials to affect exchange rate trends, even if the exchange rate toolbox has been adequate to date in steering the exchange rate. Market participants, for example, see the yuan's recent strengthening against the US dollar as a political response to Moody's downgrade of China's sovereign credit rating.