Currency plan suffers in wake of turmoil engulfing the markets

China is in a currency quandary. How will it promote the yuan in global trade while at the same time use it to stabilize stock market volatility?

The People's Bank of China is holding the onshore version of the yuan at about 6.2 to the dollar, even as it pledges a bigger role for market forces. In a recent statement, the government said it would allow the currency to move in a wider range while keeping the exchange rate stable.

A freely usable yuan is a key requirement of the International Monetary Fund's Special Drawing Rights status that China is seeking. Yet loosening controls while stocks are plunging risks the kind of swings that may spur capital outflows and disrupt the world's second-biggest economy.

"This is a time of policy confusion," said Cliff Tan, East Asian head of global markets research at Bank of Tokyo-Mitsubishi UFJ Ltd in Hong Kong.

"Different departments are coming up with what can be done, but they're mutually contradictory."

This tension is being borne out in markets, where the gap between the onshore yuan and the currency's value in Hong Kong widened last week to 0.29 percent, the most since March.

JPMorgan Chase & Co and Commonwealth Bank of Australia took the State Council's statement as a sign China will relax the limit of 2 percent moves either side of a daily fixing.

Achieving SDR status would be the crowning achievement of the nation's efforts to boost global use of its currency and challenge the dominance of the dollar. The yuan failed to make the cut in 2010 because it was not deemed to be freely usable. The next five-yearly review is scheduled for November.

It is critical for China to adopt a flexible, market-based exchange rate to help correct the imbalances that are limiting domestic consumption, the IMF has said in a report.

"Let the exchange rate trade more freely within the band first and then we can talk about widening the band," said Ken Peng, a strategist at Citigroup Inc in Hong Kong.

Widening the trading band will add unwanted uncertainty at a time when financial markets are already volatile, said Koon How Heng, a Singapore-based strategist at Credit Suisse Private Bank and Wealth Management.

"There's just no strong or clear valid objective at this stage to widen the daily trading band," Heng said.

Yet some of the signs for China's currency are more positive.

Yuan trading in London has bucked the global trend of declines in April, climbing to a record $43 billion a day, up 25 percent from October, data from the Bank of England showed last week.

And the PBOC issued new rules in July making it easier for big international investors to access its bond market. There are dissenting voices, though, spurred by the rout that has wiped $4 trillion from Chinese equities.

The goals of opening up the capital account, which tracks investment flows, and making the yuan fully convertible, should be reassessed given the stock collapse, Qing Wu, a researcher at the State Council's development research center, said in a July 20 interview.

"There's still a big gap between the Chinese government's communication skills and their counterparts in developed nations," said Le Xia, an economist at Banco Bilbao Vizcaya Argentaria SA in Hong Kong.

"Authorities don't want the yuan to become "an additional problem to worry about when the equities market fluctuates."