(Yicai Global) Aug. 5 -- The fundamentals of China's economy do not support a severe weakening of the yuan, a former adviser to the country's central bank told Yicai Global, after the redback breached 7 to the US dollar for the first time in 11 years.

"Even if the exchange rate is temporarily overstretched," Yu Yongding said, "it will eventually return to the level determined by the fundamentals, not to mention the line of defense for capital management."

China does not encourage yuan depreciation nor is it afraid of currency fluctuation, added Yu, who from 2004 to 2006 served on the Monetary Policy Committee of the People's Bank of China. "We don't interfere. We strengthen capital management."

The onshore yuan weakened 1.23 percent to 7.0258 against the greenback at 10.08 a.m. local time, breaching the key psychological level, while the offshore rate softened 1.38 percent to 7.0683, breaking 7 for the first time since the market was set up in Hong Kong in 2010. As of 3 p.m., the yuan had weakened offshore to 7.0710, while onshore it had depreciated to 7.0315.

 "The PBOC has the experience, confidence and capability of keeping the yuan's exchange rate basically stable at a reasonable and balanced level," it said in a statement posted on its website today, attributing the weaker redback to factors such as trade unilateralism and protectionist measures, as well as the expectation of additional US import tariffs on Chinese goods.

Market Move

The central bank has gradually ceased regular intervention in the foreign exchange market over the past two years and China's exchange rate system has become increasingly a floating system. Yu, who is also a member of the Chinese Academy of Social Sciences, believes that when the real test comes the PBOC will still be able to manage cross-border capital flows without directly intervening in the forex market.

In the short term, Yu said, there may be four possible effects if the exchange rate depreciates significantly, such as by more than 25 percent: a banking crisis, a corporate debt crisis, a sovereign debt crisis, and inflation.

But he said China need not worry too much about these problems, which many emerging markets are now facing. The relatively low level of overseas debt at Chinese banks and companies, and the yuan's depreciation, has not yet triggered the first two. China is not likely to have a sovereign debt crisis, either.

"As for inflation, we should be wary, but not yet, since the yuan's devaluation has so far not caused inflation to spiral out of control," he noted. "In fact, in the current situation in China, it is difficult to see a significant depreciation of the renminbi [yuan]. Using foreign exchange reserves to stabilize the exchange rate is not worth the candle."

Yu had said earlier that China should adopt a prudent attitude toward capital account convertibility. "Capital accounts should be opened in a gradual way, which worked in the past," he said. "It is not necessary to speed up now. After all, issues such as financial stability, corporate debt and reduced labor supply cannot be solved by capital account liberalization."

Corporate Risk

Yu also called on China's financial regulators to promote the development of the derivatives market, providing companies with value-preserving tools to lessen exchange rate risks.

"Enterprises must realize that in the past exchange rate risks were borne by the central bank," he said. "Now they have to bear these risks themselves."

"We don't want companies to be overly exposed to exchange rate risks and we support them in buying exchange-rate safe-haven products to avoid such risks," the PBOC said in its statement. It advised firms to focus on their business and take a "risk-neutral" financial stance, not expend too much energy on judging or speculating on exchange rate trends.

Forex derivatives should be made to lock in foreign exchange costs, the PBOC said, adding that firms should ease production and operational uncertainties and make profits from their main business rather than from trading in such derivatives.

Editor: Chen Juan