The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.
Strengthening yuan signals more currency flexibility on the way
Appreciation to record level yesterday to dent competitiveness of exports as growth slows
The yuan rose to its strongest level against the US dollar in nearly two decades yesterday, highlighting Beijing's determination to roll out more reforms to make its currency more flexible despite the short-term headwinds to exports.
The renminbi has been trading near the upper limit of its daily trading band from February till June this year. Since June, the gap between the spot rate and the daily reference rate - which is set by the central bank as the middle point of the permissible trading band - has narrowed as expectations of yuan appreciation cooled following disappointing economic data from Beijing.
But since late last month, the currency regained upward momentum as the government kept setting a stronger daily reference rate, at odds with data signalling a further slowdown that would logically prompt a weakening of the currency.
The yuan closed at 6.1192 against the US dollar in Shanghai yesterday, marking the strongest level since the end of 1993. That was again near the top of the 1 per cent range in which the currency is allowed to deviate from the daily reference rate.
Economists, however, said room for yuan appreciation from the current level was limited in the second half of this year and into 2014 as Beijing battled to keep economic growth around the 7.5 per cent mark - no mean feat given the relative loss of currency competitiveness seen since 2005 when the yuan's peg to the dollar was broken. It has strengthened by more than 30 per cent since and has gained 1.8 per cent so far this year.
"China has a domestic crisis now. The regulators want to hold money in the country … to prevent capital flight," said Andy Xie, an independent economist, who expected the currency to trade around the current level till the end of this year.
In the offshore non-deliverable forwards market, which many analysts say gives the clearest view of where foreign investors believe the currency is headed, the yuan on a 12-month view has been trading at a discount of about 2.5 per cent to the onshore spot rate.
The government kept the currency stable in 2008 in a bid to counter the global financial crisis. Now, said Xie, the regulators should continue to do so to counter a domestic economic slowdown.
Some economists believe the central bank wants to send a signal by setting the reference rate at a strong level.
"It could be a signal that Beijing wants to widen the trading band, as it mentioned earlier this year," said Liu Ligang, an economist at ANZ bank.
"By pushing the currency to an unsustainable strong side, the PBOC intends to see it overshoot to the weak side pushed by market forces. It appears this policy move could be imminent," he said.
The central bank increased the trading band to 1 per cent of either side of the reference rate from 0.5 per cent last year and the market has been expecting a further widening after a Communist Party plenary meeting in October.