China announced a new trade-weighted exchange index Dec. 11 that values the yuan against a collection of other currencies. The move made official what had originally been announced in July 2005. At that time, China's central government — after leaving the U.S. dollar-to-yuan fixed exchange rate — had stated that official government policy would begin following a basket of currencies to set the benchmark rate, though the dollar remained the largest component of the basket.
What the Chinese government did not announce, however, is exactly which currencies would constitute that basket or how much weight each would receive. In fact, China withheld this information for a full decade, up until recently, when the currency exchange rate showed strong signs of currency appreciation. Beijing has now finally provided a full list of the currencies against which it has been setting the value of the yuan for 10 years.
But what does this year's disclosure mean? On a day-to-day basis, the newly disclosed index will help leaders and markets worldwide gauge how Chinese policymakers might react to changes in currency valuations. Based on the official announcement, Chinese officials will be using the yuan's value as of Dec. 31, 2014, as their benchmark; the extent to which the currency changes in relation to that value will guide their decisions about intervening with the exchange rate.
It also means China can now stop intervening to strengthen an already overvalued currency. With the dollar appreciating against most other currencies, by extension the Chinese yuan should also depreciate if Beijing stops intervening to strengthen it. And China now has completed the requirements to enter the Special Drawing Rights reserve currency basket, the elite club of global reserve currencies acknowledged and managed by the International Monetary Fund. After campaigning for entry by fulfilling the IMF requirements, Beijing can comfortably allow its currency to depreciate reacting to downward market pressures, since the currency had previously been propped up in order to become an internationally recognized reserve currency. Revealing the composition of the currency basket gives China a legitimate reason to stop currency intervention while also letting global financial markets know why.
By telegraphing the composition of the index to the financial markets, China will be better able to manage the buying, selling and holding of the yuan worldwide. It will also be able to slow the rate at which its foreign exchange reserves have been diminishing, largely as a function of its efforts to strengthen the yuan. Apart from the specific fiscal gains China gets from the big reveal, China may also mean this to be a step toward greater credibility on the global market. Other major central banks disclose their benchmark indices as standard practice, and China may simply aim to be numbered among the financial powerhouses.