THE decision to remove the exchange rate ceiling on the yuan in China's swap markets indicates a policy reversal by the Chinese Government. The ceiling of one US dollar to 8.135 yuan was imposed in mid-April to withstand the fall of the Chinese currency. Chinese authorities still emphasise that this is a managed floating of the yuan in the swap market. But the deregulation and immediate fall in value of the yuan, to more than 10 to the US dollar, betrays the government's lack of confidence in defending the currency at any higher rate. The market will read it as a practical devaluation of the yuan by the Chinese Government - not by design, but by its weakness in the face of pressure in the financial market. With such an interpretation, it is impossible for the market to react normally, as expected by the Chinese Government, and restore the value of the yuan to a credible level closer to its ''actual'' value. On the contrary, speculators and others will find the present rate extremely vulnerable, and will find it highly profitable to push the rate down even further, against the wishes of the government. The Chinese currency crisis is not so much due to rising high inflation and deficits in the trade balance. These constitute the conditions for only a gradual sliding down of the exchange rate, not the kind of drastic fall we have witnessed recently. Two other factors are more crucial in the present crisis. First, there is the widespread inflationary expectation of the Chinese population and the corporate sector. In the last four to five months, we have seen panic buying beginning, from consumer durables to gold ornaments and, finally, to foreign exchange. People wanting to protect their financial assets against out-of-control inflation have favoured foreign currency over all other commodities. The frantic buying of foreign exchange and subsequent depreciation of the yuan has activated a vicious circle which, if neglected on the grounds of free market regulation, may end only when demand and resources (in terms of Chinese currency) exhaust. However, with the vast amount of liquid money in the hands of the Chinese population and the corporate sector and the lack of effective control over money created by the state banks, this may take a long time. By the time it finally happens, the Chinese economy may already have been ruined by the financial chaos which it has created. The second factor is the massive outward flight of capital. The transfer of capital out of China may be for good reasons, such as to establish Chinese multinational corporations. However, the timing is inappropriate. With overheating in the economy, domestic inflation and the worsening international balance of payments position, China is unable to endure any further depreciation and capital loss. So long as there is a persistent depreciation in the yuan, investing in foreign exchange remains a lucrative business and the demand for foreign exchange in China will not abate. Worst of all, the Chinese Government-sanctioned free conversion of the yuan in Hongkong allows the flight of capital out of China to continue. This availability of foreign exchange supply will initially help to restrain the depreciation of the yuan, but it will also sustain the trend of depreciation. Unless there is a determination by the Chinese Government to rectify the present problems of overheating, the downward pressure on the yuan will continue to grow. If the Chinese Government is able to enforce policies to cool down the economy, the present inflationary spiral could be brought under control within six months. After that, inflation could begin to fall abruptly. Many examples of currency crises in western market economies have demonstrated that stabilising currency does not help to suppress inflation. But without an immediate stabilisation of the currency, inflation is even more out of control. A free market approach may be convincing in the classroombut, faced with a real crisis, it may create more problems than it can resolve.