THE yuan has surprised analysts recently by not only stabilising after last year's big falls, but has even managed to achieve a humble 1.2 per cent appreciation against the US dollar. Nicholas Kwan, senior economist at Merrill Lynch, in a bulletin on the currency offers an explanation and some pointers to future developments and reform. Speculation has actually been focusing on when the next de-facto devaluation was due. Merrill argues it could stay firm for another three to six months before facing a gradual decline of five to six per cent a year annually. The investment bank argues more efficient management of the exchange mechanism and a strong external payments position will be the key to obtaining exchange rate stability. Direct government intervention has been the first tool of stabilisation in the yuan to date. Having fallen 33 per cent in the country's swap markets a year ago, and following the unification of rates, the government is determined to fend off any speculatory attack. Merrill says this has not been achieved without cost, as reserves in the first four months of the year dropped US$1.4 billion. The rapid reserve build-up in the second half has put China among the top 12 largest reserve holders of the world, reaching $31.9 billion, sufficient to cover 3.6 months of imports. Contributory stability measures have been the forced redemption of foreign exchange quotas and a mandatory cutback of forex allocations. But tight monetary policy has probably been the most effective, designed to curb domestic demand, says Merrill. Demand for forex dried up as importers ran short of yuan to buy forex. Instead companies had to sell their forex holdings in exchange for yuan. The unification of the yuan swap and official rates has meant stabilising the currency has been made more manageable. Since its introduction in January the yuan rate against the US dollar has moved not more than 1.5 per cent. For now the rate may reflect market valuation, but there is a danger the authorities may take an inflexible view towards the currency, trying to fix it at current rates. Furthermore, the administrative bureaucracy supporting the arrangement, using retention accounts, is in danger of bringing in a quota system again. The current embryonic foreign exchange markets need to be developed, adding more regional swap centres, merging current swap centres with the interbank network and providing for better over-the-counter services. This will not help maintain a stable yuan unless it is backed by fundamental change: a turnaround in the country's external payments position. Over the past six months, China has reversed its monthly deficit from $4.6 billion in December to a margin surplus in June. Factors behind this habe been the cooling domestic economy and the devaluation of the yuan. Merrill argues China's overall payments surplus could be much larger if it were not for substantial outward investments, especially under errors and omissions, which in 1991 to 1993 amounted to $24.8 billion, more than China's foreign exchange reserve at 1993 year-end. In 1993 the outflow under this item is estimated at $9.8 billion, says Merrill. These flows represent flight capital, many economists believe. Overall pressure on outflows, in terms of debt repayments, will remain because it is estimated that China will join the $100 billion debt club in the near future. External debt grew by more than 20.6 per cent last year to $83.6 billion. Merrill says that should expert growth remain at 15 per cent a year, as it has over the past 15 years, then the country's debt service ratio should stay below 13 per cent until 1997. One major factor driving errors and omissions capital flow has been restrictive controls on capital and preferential treatment for foreign investors. A substantial amount of this money is believed to have been parked in Hong Kong under private or street names. Obviously, more restrictive controls may be the natural response, but Merrill argues more effective action would be to remove restraints on capital flows and offer a level playing field for both public and private, domestic and foreign investors.