From July 2005 until last December, China's yuan appreciated steadily.
But then the currency fell unexpectedly, hitting the bottom of the daily trading band set by the People's Bank of China for 11 sessions in a row. Although the yuan has since returned to its previous trajectory of slow appreciation, the episode may have signalled a permanent change in the pattern of the exchange rate's movement.
As long as China was running a trade surplus and receiving net inflows of foreign direct investment, the yuan remained under upward pressure. Short-term capital flows had little impact on the direction of the currency's exchange rate.
There were two reasons for this. First, thanks to an effective - albeit porous - capital-control regime in China, short-term "hot money" (capital coming into China aimed at arbitrage, rent-seeking, and speculation) could not enter (and then leave) freely and swiftly.
Second, short-term capital flows usually would strengthen, rather than weaken, upward pressure on the yuan's exchange rate, because speculators, persuaded by China's gradual approach to revaluation, bet on appreciation.
So why, if China was still running a decent current-account surplus and a long-term capital surplus, did the yuan suddenly depreciate, forcing the central bank to intervene (although not very vigorously) to prevent it from falling further?
Many economists outside of China have argued that the December depreciation resulted from betting by investors that Chinese policymakers, facing the prospect of a hard economic landing, would slow or halt currency appreciation. But if that were true, we would now be seeing significant long-term capital outflows and heavy selling of the yuan for dollars.
We see neither reaction. More importantly, the yuan's slow appreciation resumed fairly promptly after December's dip, while investors' bearish sentiments about China's economy remain consistent.
In fact, the sudden fall in December reflected China's liberalisation of cross-border capital flows. That process began in April 2009, when China launched the pilot RMB Trade Settlement Scheme (RTSS), which enables enterprises, especially larger ones, to channel their funds between mainland China and Hong Kong. As a result, an offshore yuan market, known as the CNH market, was created in Hong Kong alongside the onshore market, known as the CNY market.
But, in contrast to the CNY, the CNH is a free market. Given expectations of yuan appreciation and a positive interest-rate spread between mainland China and Hong Kong, the yuan had a higher value in dollar terms on the CNH than on the CNY market. That difference led to active exchange-rate arbitrage by mainland importers and multinational firms - one form of capital inflows from Hong Kong to the mainland. Correspondingly, yuan liabilities owed by mainland Chinese and multinationals increased, as did yuan assets held by Hong Kong residents.
Exchange-rate arbitrage by mainland importers and multinationals creates upward pressure on the CNY and downward pressure on the CNH. In an economy with flexible interest and exchange rates, arbitrage eliminates the exchange-rate spread quickly. But, because China's exchange rate and interest rates are inflexible, the CNH-CNY spread persists, and arbitrageurs are able to reap fat profits at the economy's expense.
Last September, however, financial conditions changed suddenly in Hong Kong. The liquidity shortage caused by the European sovereign debt crisis led developed countries' banks - especially European banks with exposure in Hong Kong - to withdraw their funds, taking dollars with them. The CNH fell against the dollar. At the same time, the shortage of dollars had not yet affected the CNY, which remained relatively stable.
The CNH, therefore, became cheaper than the CNY. Consequently, mainland importers and multinationals stopped buying dollars from the CNH market and returned to the CNY market. At the same time, mainland exporters stopped selling dollars in the CNY market and turned to the CNH.
The dollar shortage created depreciation pressures on the CNY, which the People's Bank declined to offset. The CNY was thus bound to fall, which it did last September.
Reverse arbitrage meant capital outflows from the Chinese mainland. Correspondingly, yuan liabilities owed by mainlanders and multinationals decreased, as did yuan assets held in Hong Kong. Increases in financing costs and uncertainty about yuan appreciation prompted a partial sell-off of the yuanin Hong Kong.
In short, because the RTSS made cross-border capital movements easier, short-term flows have become a major factor in determining the yuan's exchange rate. External shocks affect the offshore exchange rate first, then feed through to the onshore exchange rate.
The yuan will continue to appreciate in the near future, owing to strong economic fundamentals, but the inherent instability of short-term capital flows will make its exchange rate more volatile.
This change will pose new challenges for the US and China, particularly as they engage in a fresh round of debate about China's exchange-rate policy.
Yu Yongding, the president of the China Society of World Economics, is a former member of the monetary policy committee of the People's Bank of China and the former director of the Chinese Academy of Sciences Institute of World Economics and Politics.
* Project Syndicate