An employee counts 100 yuan ($15) banknotes at a bank in Lianyungang, in eastern China's Jiangsu province, Jan. 7, 2016. AFP/Getty Images

SHANGHAI — China’s yuan this week fell to its lowest level against the dollar in five years, and the gap between the official price fixed by the central bank in China and the offshore price for international trading rose some 2 percent. The offshore yuan traded as low as 6.76 this week, its lowest since such trading began in 2010, making these, as one analyst put it, “two separate currencies”.

The falls took markets by surprise and prompted questions about whether authorities were seeking a competitive devaluation to boost exports, which have slumped since last year, or whether they had simply decided to let markets take their course.

Experts have been predicting further significant falls in the value of the yuan since last August when the government abruptly devalued the currency about 3 percent from its level of 6.2 to the dollar where it had been pegged for many years. The government said this was mainly to introduce a new, more market-based way of fixing the price of the currency, and to adjust for a sharp rise in the dollar, rather than simply to boost exports. The yuan currently is allowed to fluctuate 2 percent against the dollar each day.

In practice, though, the currency only fell a further 2 percent by the end of December, due in part to China’s central bank putting hundreds of billions of dollars into buying yuan to shore it up and stem capital outflows, which rose sharply last year. In an apparent indication of the scale of the intervention, China’s foreign exchange reserves were depleted by nearly $108 billion in December alone.

The Chinese government also has said repeatedly since August it is not interested in sparking a currency war by devaluing the yuan to boost exports. In fact, it says, it wants to retool the economy to make it less dependent on exports — currently some 20 percent of gross domestic product — and boost domestic demand.

So this week’s sharp devaluations took markets by surprise. On Tuesday, and then again on Thursday, the central bank, the People’s Bank of China (PBoC), set the yuan’s official midpoint rate to the dollar at its lowest level in some five years; Thursday’s rate of 6.5646 to the dollar represented its biggest drop in five months.

Some analysts said the move raised fears of a competitive devaluation, which could spread to global markets. To many observers it seems, as ANZ Bank analysts Li-gang Liu and Raymong Yeung put it Thursday, “the central bank wants to state clearly its willingness to establish a flexible exchange rate regime, moving away from the interventionist stance a few weeks ago” and letting offshore markets have their say.

Still Too High’

Such a move would make sense, some analysts said. Gary Liu, executive deputy director of the Lujiazui Institute for International Finance at Shanghai’s China Europe International Business School (CEIBS), said allowing the yuan to float freely would both help boost exports and stem capital outflows, based on a lack of faith in the currency, which have been exacerbated by the Federal Reserve’s decision to raise U.S. interest rates in December.

“The yuan is still too high — and if you keep denying this, then more money will flow out of the currency. It’s better to just let it find its natural level and restore confidence,” Liu told International Business Times.

Yet no sooner has this apparent shift in currency policy been digested than the PBoC seemed to change tack. On Thursday it “wrong-footed traders,” as Reuters put it, by propping up the yuan in offshore trading. And on Friday it set the midrate for the yuan-dollar slightly higher for the first time in nearly two weeks while state-backed banks also were reported to be taking action to shore up its value domestically.

Pedestrians walk past an electronic board displaying the benchmark Hang Seng Index in Hong Kong Jan. 7, 2016. Hong Kong stocks slumped as China weakened its yuan-dollar value to a five-year low. Philippe Lopez/AFP/Getty Images

And Chinese state media Friday highlighted a statement from the PBoC reiterating its insistence there “is no basis for a sustained depreciation of the yuan,” which it said had been stable against a basket of currencies in 2015. Late last year the PBoC announced it was gradually moving to calculate the yuan’s value against a basket of currencies including the euro and yen, both of which have fallen further than the yuan in the past year. Some analysts interpreted these moves as "a signal it [the government] does not intend to keep allowing the yuan to fall.”

Others were simply baffled as to whether the authorities were seeking to prop up the currency, embrace market forces or even pursue a policy of competitive devaluation.

The government has pledged to let the market play a greater role in both its economic and monetary policy in the coming years, yet with growth slowing to 6.9 percent, its lowest rate in six years, in the third quarter of 2015, some analysts have said “a more interventionist approach is likely. Either way, even the official China Daily acknowledged the swings have left the markets perplexed.”

Policy Drift

The fall in the currency, and a sense of policy drift on the issue, were seen by some Chinese analysts as a major factor in the sharp falls of China’s CSI 300 Index, which lost 10 percent of its value this week.

Christopher Balding, associate professor of political economics at Peking University HSBC Business School in Shenzhen, told IBT that, overall, “Beijng at least seems content to allow the yuan to drop in line with market forces. They’re not going to fight that hard to prop it up.”

Indeed, he said, there is currently “a unique confluence of interests on the issue: There are smart guys in the PBoC, they know what’s going on, they see there’s enormous pressure on the [yuan]. So they say we need to liberalize the exchange rate, we can’t keep propping this up. It’s going to be throwing good money after bad. And at the same time you have the industrial guys, the ministry of commerce, who say, what can we do to stimulate exports, why don’t we let the [yuan] drop."

In Balding's view, given the falls in other emerging market currencies against the dollar over the past year — many are down some 30 percent — "it would not be crazy to think the yuan needs to fall 20 percent to be in line with emerging market currencies."

In practice, however, “there are still political imperatives” which work against a completely uncontrolled fall, and could explain this week’s apparent contradictions, he suggested. Many analysts say President Xi Jinping now has major input on economic policy and is particularly opposed to drastic changes.

“If they let the exchange rate flow tomorrow you’d probably be looking at at least a 20 percent change overnight," Balding added. "But they know that any large movement in financial markets create a lot of worry, it would freak out a lot of people in China and roil world markets. So the impression I get is that it’s like a car driving downhill — they don’t want to step on the gas, and at the same time they can’t slam on the brakes because they’ll lose if they do that anyway," he said. "So they’re kind of tapping on the brakes on the way downhill, to try to ease some of the pressure, stimulate exports, get back to [the] value they’re comfortable with, without causing a crisis or triggering a stampede.

In practice, Balding suggested, the authorities may be seeking to allow the yuan to fall some 7 percent — though some analysts believe this would have only a limited impact on China’s exports. Others agree with this assessment: Liu Dongliang of China Merchants Bank told the official Global Times this week the yuan would likely depreciate 5-10 percent in 2016.

20 Percent Devaluation Reasonable

CEIBS’ Gary Liu also argued that a devaluation of 20 percent would be reasonable — but he agreed political factors make it unlikely this would be done suddenly.

“Few people disagree with the need for devaluation,” he said. “But the PBoC is worried that a big drop would cause more market anxiety.”

However Liu said a continuing gradual devaluation, which he said the bank was seeking, could be counterproductive. "If the Central Bank keeps saying the yuan won't devalue [much], this will just encourage more capital flight," he said. "I believe it should be devalued about 20 percent in a one-off move." And he denied this would panic investors or cause a collapse in confidence.

"It depends on how you explain it," he said. "You need to tell people why we should devalue — that this is a good chance to free the yuan [from] its peg to the U.S. dollar and fix it to a basket of currencies. The main thing is to let it fall to a level where poeople think it's not obviously overvalued — then they'll believe it won’t fall again, and the hot money won’t leave."

Liu also said spending large sums of foreign exchange to prop up the yuan was a waste of money — “You can’t prop up a bubble” — and allowing the country's foreign exchange reserves to decline is a worrying trend.

However, not everyone sees this as a dangerous policy. Paul Mackel, Head of Global Emerging Markets Foreign Exchange Research at HSBC — who wrote this week he expects the yuan to soften this year, but no lower than 6.7 to the dollar — said China’s foreign exchange reserves remain significant. They currently stand at $3.33 trillion — and while this figure is down from a high of $3.99 trillion in May 2014, Mackel argued not all the money has been spent on propping up the currency. And he said this level is more than sufficient for a nation that has seen its trade surplus continue to rise on the past year as imports slow faster than exports.

“China has one of the strongest external balance sheets globally, and the PBoC does not, and, indeed, should not, fear using its reserves,” Mackel and his team of analysts wrote in a report this week. “The PBoC … has been finding ways to make better use of its foreign exchange reserves, such as to recapitalize policy banks and support Chinese corporates' overseas expansion. Given its goal for the [yuan] to be a major global reserve currency,” he added, “it can comfortably hold much lower reserves than it does today. The U.S. Fed and the ECB [European Central Bank], for example, hold very little foreign exchange reserves.”

However, Peking University’s Christopher Balding said such confidence might be exaggerated.

“The International Monetary Fund has said that China should maintain at least $2.6 trillion in reserves to finance economic activity," Balding said. "And if they’re going through foreign exchange reserves at a rate of almost $100 billion a month, then they have basically six months left; even if they wait until reserves fall to $1.5 trillion or $2 trillion, they only have 12 to 18 months before they have to make a decision on what to do with floating and the fix.”

Yet precisely what that decision will be remains uncertain. And with some experts saying political considerations are increasingly taking precedence over market forces when it comes to official policymaking in China, fixing the exchange rate both effectively and advantageously may be a tough challenge for China’s leaders in the year ahead.