China to Tighten Controls on Yuan

China said Friday it is considering a change to its mechanism for managing its currency to buffer it against market forces, in an apparent step back from liberalization pledges.

The potential new system would introduce a “counter-cyclical factor” to China’s current system of allowing the yuan to trade within a government-set band, according to a statement on the website of the Foreign Exchange Trade System, an agency under the People’s Bank of China, AFP reported.

The statement did not explain how the mechanism would work but said it would take into account the country’s economic “fundamentals” as a counter to market forces.

“The goal is to properly hedge” against fluctuations based on market sentiment and “to ease the potential herd effect,” it said, adding that the current system was vulnerable to “irrational expectations”.

China only allows the yuan to rise or fall 2% on either side of rate fixed daily.

The band has been in place for more than a decade, gradually widened over the years, and authorities have taken steps to make it more market-based, earning plaudits for China and helping the yuan gain greater world recognition.

Last October, it joined the dollar, pound, yen and euro in the IMF’s “special drawing rights” reserve currency basket.

But since last year, the yuan has plummeted to its lowest levels against the dollar in several years as the greenback spiked and Chinese investors and businesses moved huge sums of money offshore.

Sean Callow, a senior currency strategist at Westpac Banking Corp. in Sydney, told Bloomberg News: “The authorities’ actions give the impression that they are more worried about yuan stability than declared in their public statements.”

China has pledged to allow market forces to play a bigger role in its capital markets. But besides a slowing economy, authorities are currently grappling with mounting debt that this week earned China its first credit rating downgrade in nearly three decades, from Moody’s.

Having greater control over the currency could help authorities maintain yuan stability during the debt-reduction campaign.

 Further Downgrade Possible

China’s structural reforms will not be enough to arrest its rising debt and another credit rating downgrade for the country is possible unless it gets its ballooning borrowing in check, two officials at Moody’s ratings agency have said.

Doubling down on comments earlier this week that China’s financial strength will be eroded because of huge corporate and household debt, Moody’s said the country’s “vast reform agenda” would not be enough to prevent borrowing from weighing on economic growth.

China may no longer get an A1 rating if there were signs that debt was growing at a pace that exceeded Moody’s expectations, Li Xiujun, vice president of credit strategy and standards at the ratings agency, said in a webcast with his colleague Marie Diron on Thursday.

“If in the future China’s structural reforms can prevent its leverage from rising more effectively without increasing risks in the banking and shadow banking sector, then it will have a positive impact on China’s rating,” Li said.

But Li added: “If there are signs that China’s debt will keep rising and the rate of growth is beyond our expectations, leading to serious capital misallocation, then it will continue to weigh on economic growth in the medium term and impact the sovereign rating negatively.