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The International Monetary Fund said China’s move to link the yuan’s value to market forces is an encouraging step toward what may become a freely floated currency within the next few years.

The changes by China will help it gradually transition “from a tightly managed system linked to the U.S. dollar to one that is more open and more flexible and more responsive to market conditions,” Markus Rodlauer, the IMF’s mission chief to China, said on a conference call Friday. The currency ought to move to “free float” within two to three years, he said.

Rodlauer reiterated the IMF’s assessment that the yuan is no longer undervalued, even after the currency dropped nearly 3 percent this week. “What has happened now over the past few days does not change our assessment,” he said, noting a substantial appreciation during the past year.

The yuan depreciated 2.9 percent this week after the People’s Bank of China announced its move Aug. 11 toward a more market-determined rate. The IMF said later the same day the move “appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate.”

The Chinese government should put in place an “effectively” floating rate for the yuan before fully liberalizing its capital markets, the Washington-based fund said in its annual assessment released Friday of the Chinese economy, which the IMF now says is the world’s biggest, taking purchasing-power differences into account.

Bigger Role

Moving to a free float is “necessary for allowing the market to play a more decisive role in the economy, rebalancing toward consumption, and maintaining an independent monetary policy as the capital account opens,” the IMF said in the report dated July 7, which was written before China devalued the yuan this week.

The fund is reviewing a bid by China to have the yuan included in the basket of currencies that make up the IMF’s Special Drawing Rights, which countries can count as a reserve asset. Approval would boost China’s efforts to have the yuan considered a reserve currency, alongside the U.S. dollar, euro, yen and British pound.

IMF staff also recommended curtailing interventions such as measures China took recently to stem a rout in the nation’s stock market. Chinese policy makers went to unprecedented lengths to put a floor under the market as the Shanghai Composite Index slumped more than 30 percent in four weeks through July 8.

Moral Hazard

The “heavy intervention created risks exacerbating ‘moral hazard,’” fostering a perception the government wouldn’t let prices fall below a certain level, IMF staff said in the report Friday. “This set of interventions needs to be curtailed to permit a return to normal price discovery,” the report stated.

In an effort to bolster consumer confidence and prevent soured loans backed by equities from infecting the financial system, China banned large shareholders from selling stakes, ordered state-run institutions to buy shares and let more than half of the companies on mainland exchanges halt trading.

The IMF said China is moving into a phase of “slower, yet safer and more sustainable” growth. The fund reiterated its projection that the economy will grow 6.8 percent this year, down from 7.4 percent in 2014. Growth will slow to 6.3 percent next year, as the IMF indicated last month.

Gross domestic product will expand 6 percent in 2017 before rebounding “modestly,” the fund said. Growth should be allowed to slow to 6 percent to 6.5 percent per year to address vulnerabilities in the economy.

China’s reliance on credit-financed investment as the primary engine of growth since the financial crisis has created “large vulnerabilities” in the fiscal, real estate, financial and corporate sectors, the fund said.

“Thus, a key challenge is to ensure sufficient progress in reducing vulnerabilities while preventing growth from slowing too much,” IMF staff said. “Over the medium term, this unpleasant tradeoff can only be improved by structural reforms that create new sources of growth.”