Since the August 2015 exchange rate reform,which effectively devalued the renminbi,the market has been alert to the currency's short-term risks. Short-term volatility was heightened after the People's Bank of China rolled out its formula for setting the daily parity rate,which guides trading,using the previous day's closing price plus a mid-rate against a basket of currencies. At the same time,expectations for the renminbi's longer term trend vary considerably. So why is it that authorities repeatedly state that there are no fundamental factors that dictate a depreciation of the renminbi -- yet investors continue to see weakness ahead? In fact,they are looking at exchange rate trends from completely different angles. The exchange rate reflects complex variables; on the one hand,it is a relative price for a commodity determined by economic fundamentals,while on the other hand it is an asset price affected by capital flows.

Foreign Exchange Market Structure

Before explaining exchange rate trend,let's first take a look at the structure of China's foreign exchange market. There are two key features to China's domestic foreign exchange market: one is that it is restricted by the principle of real needs -- that a foreign exchange transaction must have a basis in real foreign trade business. The other is that there are a limited number of trading parties in the market. China's foreign exchange market is a closed market which takes interbank trading as its core,with banks and other financial institutions as the key players.

Under this structure,the renminbi exchange rate is heavily dependent on the trade surplus,because trade-related entities are the main source of supply and demand.  China's capital account has not been fully opened,so supply and demand from the capital market is not fully reflected in foreign exchange market trading.